If you look at the top 10 performing stocks on U.S. exchanges for 2012 to date, you’ll see that seven of these stocks are small caps with market caps of $1 billion or less

As a smart investor you might ask yourself: Why would I invest in high-risk stocks that trade for a few dollars, a dollar, or even less… for pennies?

It’s true; these stocks are highly volatile, hard to analyze and very risky.

But this is exactly why investors who can stomach risk should be interested, because with more risk you also have the potential for more reward.

At Investment U we call it “reward opportunity risk.” Simply, you have the opportunity to be rewarded with extreme gains when you take on extreme risks.

Capturing major gains

If you look at the top 10 performing stocks on U.S. exchanges for 2012 to date, you’ll see that seven of these stocks are small caps with market caps of $1 billion or less, and three of them trade for less than $5… talk about cheap.

Top-10 Performing Stock of 2012 YTD:

But in order to capture gains like the ones listed above, you’ll need a methodology.

Distinguishing a contender from a pretender

A metric to consider when looking at small cap stocks is insider buying. More importantly, cluster buying.

Cluster buying happens when more than three “C-Level” (CEO, CFO, CIO, etc.) and directors buy up substantial amounts of shares in a relatively close period of time.

And these have to be substantially large.

If a CEO buys 100,000 shares of a stock trading at 20 cents (a $20,000 investment) this is not what we’re talking about.

We want it to be large and hopefully more than their compensation.

If you find multiple C-Levels buying $300,000 or more worth of shares in the underlining stock, then you’ve found the cluster buying we’re talking about. A helpful tool to track insider buying and selling is insiderinsights.com; they have a daily headline list of all insider transactions.

Investors should also focus on research and development (R&D) for companies that are on the forefront of innovation. We want these small technological innovators to be reinvesting a healthy potion of their revenue back into the company, specifically in R&D.

The current sticker price for a patent is about $1 million, and takes around three to four years to complete. Many small companies’ lifelines depend on patents that will protect the products they create from the big dogs above them. (And these patents are what make small competitors prime takeover targets, which any shareholder will welcome.)

If a company believes it’s legitimate, it’ll take every opportunity possible to reinvest in the company to build and develop their intellectual property portfolio.

Investors should look for small caps that are reinvesting at least 10% to 20% of revenue into R&D and have 50% to 60% of their employees working in R&D. (You can dive into a company’s 10-Ks and 10-Qs to find this type of information.)

What to avoid

First, avoid any stock trading under $1 dollar that doesn’t have sales and isn’t listed on a major exchange.

Over-the-counter stocks, or what some call pink sheets, can put you into a liquidity trap where you can’t get in or out of a stock due to extremely low trading volume. Stick to the major exchanges and make sure there’s adequate volume on the stock.

And beware, there are a lot of promoters out there who get paid to recommend extremely risky penny stocks, and you don’t want to get caught up in the hype. Stay away from these stocks, they aren’t worth your time.

Second, if there’s little or no data about a stock listed on yahoofinance.com or googlefinance.com stop right there, go no further and avoid this stock.

Be disciplined

As I’ve already mentioned, small caps hold a large amount of risk so you have to be disciplined.

Make sure that you follow some sort of stop loss policy. At Investment U our general guideline is a 25% stop policy (you can read more about stop loss orders here) but since small caps are much more volatile, investors could consider anywhere from a 35% to 50% stop loss policy.

Simply put, if you buy a stock and it drops 35% you would cut your losses short and sell it immediately.

It’s entirely up to you how much flexibility you want in your stop loss, just make sure you have one and stick to it.

You should also consider your position sizing.

Since small caps are riskier, investors should invest no more than 1% of their portfolio into a single position. If the trade works out, great! You made 20 times your investment. But if it doesn’t, it’s no big deal since you didn’t dump a ton of money into it.

Investors with a stomach for risk should consider adding a few small cap stocks to their portfolio. Soon enough you might find yourself holding a stock that has tripled or quadrupled in value in a short period of time.

Just make sure to do your due diligence using some of the guidelines above, limit your position size and always, always, always be disciplined.