A Year-End Strategy for Small-Cap Investors

When the conditions are right, small caps give investors the best chance at generating triple-digit gains.

But the last few months have been some of the toughest conditions for small caps since 2008.

My colleague, Phase 1 editor Frank Curzio, and I have seen a lot in the small-cap universe over the past decade. In the last few months, our daily conversations have sounded more like something you'd overhear on a battlefield.

The latest news about China's economy or Europe's banks is sending small caps up or down 10% in a couple days. It doesn't matter whether a company's business has anything to do with China or Europe.

And that's why we talk about strategy now... more than ever.

During one three-month stretch this summer, more stocks in the small-cap Russell 2000 were down 50% than were in positive territory. In October, the Russell soared more than 25% in just over three weeks.

Frank and I saw these huge swings starting in July. So we made adjustments in micro-cap-focused Phase 1 Investor and Penny Stock Specialist.

The first adjustment was buying half-sized positions. We told readers that if they normally put $2,000 into a new position, they should only commit $1,000 at the start. Buying a half-sized position leaves investors with room to add the second half at a much better price if the market makes a big move lower over the following weeks.

We've used this strategy frequently this summer and fall. And we've secured 5%-10% "discounts" on our picks. More than once, that's pushed what might have been a losing position into breakeven or profitable territory.

The second strategy change is taking profits sooner than normal. When the market is zig-zagging all over the place, a normal "buy and hold" strategy doesn't work well. If you want to improve your returns, traders have to be willing to take advantage of rallies by selling a portion of winning positions.

For example, in July we sold half a position in a small-cap silver miner that was up 30% since the original recommendation in Penny Stock Specialist. It pulled back more than 20% shortly after.

In September, we sold a half-position in a small energy stock. Shares jumped 40% in just three weeks. Penny Stock Specialist readers were sitting on a 100% gain from the original recommendation price. Just after we sold, the stock saw a nearly 30% correction.

Back in September, Frank noted that the best time to buy small-cap stocks is when the fearindex – the "VIX" – is below 25. We could stay above that level for months.