Tonight’s Trading Lesson

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.

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)
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.