Know The Sector Before You Trade The Stock
Stock sector analysis involves taking one step back from a trade and examining the larger market context to select stocks with the best chances for success.
But you can also use sectors for more than just analysis. With various stock and option exchanges offering an expanding selection of new sector-based trading instruments, you have the added options of trading sectors directly or in combination with individual stocks.
We’ll take a look at what sectors are, how they work, how to analyze them, and how to use them as trading tools.
What’s a stock sector index?
A sector index is simply an average value of a basket of representative stocks. Just as the Dow Jones Industrial Average (DJIA) is composed of 30 large-cap “industrial” stocks (at least at one time they were all considered industrial), sectors contain stocks in a particular industry.
For example, the Biotech Index (BTK) is composed of 15 well-known biotech stocks, including Amgen (AMGN), Biogen (BGEN), and Medimmune (MEDI). Most sector indices weight their individual stocks to more accurately reflect the flow of money in and out of the sector. The larger the company, the greater the weighting. It takes more money to move a larger-capitalized company (measured by outstanding shares times price). As a result, a one-point move in a large company affects a sector index more than a similar move in a smaller issue. For instance, Bank of America (BAC) is the largest bank in the S&P Bank Index (BIX). Therefore, it has the highest weighting (16.18%) of all the stocks in that sector.
It is important to keep in mind how moves in dominant stocks can impact their respective sector indexes. If a company like Bank of America spiked down dramatically, for example, it could depress the Bank Index–even if the other stocks were flat-to-up on the day. This could lead you to conclude there was weakness in the sector when none (or very little) actually existed, which in turn might influence a trade you might make in an individual stock in that sector.
Relative strength, technical analysis, and sectors
The old stock market adage “A rising tide lifts all boats” is as relevant to individual sectors as it is to the major averages. In fact, because sectors are more directly tied to the individual issues, the sector action is often more important than the overall stock market condition.
Essentially, sector analysis acts as a filtering tool, allowing you to search for strong or weak stocks based on the behavior of the different sector indexes. Applying a top-down approach, you would first identify the strongest sectors, and then look for individual stocks for buying opportunities. By the same token, you would focus on stocks in the weakest sectors when looking for short candidates. This way, if you were not lucky enough to pick the strongest (or weakest, for shorting) stock, the strength (or weakness) of the sector would likely cause your stock to rise (or fall) along with it.
But this does not mean you should automatically buy stocks in a “hot” sector or automatically short stocks in a “cold” one. The strength or weakness in a particular sector must be placed in the context of the larger technical picture.
Patterns like breakouts, cups-and-handles, double tops and bottoms, and pullbacks apply to sectors just as they apply to individual stocks. In fact, because sector indices average the performance of a basket of stocks, they tend to filter out noise often associated with individual issues, making it easier to interpret the technical picture.
In Figure 1, notice the Amex Telecommunication Index (XTC) made a huge run-up after forming a cup-and-handle pattern. Also notice the short-term weakness in the pullbacks actually offered buying opportunities because the overall trend remained up.
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Figure 1. Technical analysis applies to sectors just as it does to individual stocks. Make sure you analyze the technical picture when using relative strength analysis of sectors. Notice the large move out of the cup-and-handle pattern, and the short-term pullbacks that presented additional buying opportunities. Source: Omega Research. |
You can use technical analysis to get a more specific picture of the bullish or bearish prospects for a sector and the stocks in it. A simple approach would be to wait for a bullish technical signal in a sector, perhaps an upside breakout or cross above a moving average, before taking a long position in one of its component stocks. In Figure 1, for example, the bullish signal provided by the completion of the cup-and-handle pattern could have been used to time individual stock purchases in the sector.
Options, sector funds, and basket stocks–trading the sector as a whole
In addition to analyzing sectors to find the best individual stock opportunities, you can also trade sectors themselves. As previously mentioned, it’s often easier to get a read on a sector than it is on an individual issue. If you feel strongly about a sector but do not have any preference for an individual stock in it, you could buy (or sell) the entire sector using sector options, sector mutual funds, or baskets traded on a number of exchanges.
The simplest strategy would be to buy sector index calls when bullish on a particular sector or buy puts when bearish (you could also sell options if you wanted to take in premium and were willing to assume the risk of such naked positions). An alternative is mutual fund switching, where you move from fund to fund to stay in the “hot” sectors.
Also, exchanges have recently begun to introduce new products that allow you to purchase all of the shares of an index by just buying one stock. For instance, you can buy or sell all of the stocks of the NASDAQ 100 through the newly introduced [QQQ>QQQ] shares, which behave like an index fund but are traded like a stock. The number of instruments like this, focusing on particular stock sectors, is rapidly growing.
Table 1 shows some of the more active sector indexes tracked by TradingMarkets.com. Options on these indexes trade on the American Stock Exchange, the Philadelphia Stock Exchange, and the Chicago Board Options Exchange. For more information regarding these and other indexes, visit the Web sites of the following exchanges: www.amex.com, www.phlx.com and www.cboe.com.
Wrapping up
Sector analysis is a simple but effective tool. Because sectors are averages of baskets of stocks, they often filter out “noise” found in individual issues and provide a clearer technical picture.
In general, you should look for buying opportunities in stocks in strong sectors and shorting opportunities in stocks in weak sectors. When analyzing the relative strength of a sector, always check the larger technical picture to gauge its short- and long-term outlook.
Finally, if you believe a sector will trend but do not have a bias towards any individual stocks, you could buy or sell the sector using options, mutual funds, or sector basket stocks like the SPDRs and the Nasdaq 100 shares.
| Sector | Symbol |
|---|---|
| Banks | BKX [$BKX.X>$BKX.X] and BIX [$BIX.X>$BIX.X] |
| Forest and Paper Products | FPP [$FPP.X>$FPP.X] |
| Gold/Silver Sector | XAU [$XAU.X>$XAU.X] |
| Semiconductor | SOX [$SOX.X>$SOX.X] |
| Internet | DOT [$DOT.X>$DOT.X] and IIX [$IIX.X>$IIX.X] |
| Consumer Index | CMR [$CMR.X>$CMR.X] |
| Japan Index | JPN [$JPN.X>$JPN.X] |
| Mexico Index | MXY [$MXY.X>$MXY.X] |
| Biotechnology Index | BTK [$BTK.X>$BTK.X] |
| Pharmaceutical Index | DRG [$DRG.X>$DRG.X] |
| Airline Index | XAL [$XAL.X>$XAL.X] |
| Securities Broker/Dealer | XBD [$XBD.X>$XBD.X] |
| Computer Technology | XCI [$XCI.X>$XCI.X] |
| North American Telecommunications | XTC [$XTC.X>$XTC.X] |
| Gaming | GAX [$GAX.X>$GAX.X] |
Table 1. Most actively traded sector indexes tracked by TradingMarkets.com.