Trading The QQQ

WHAT IS THE QQQ?

The QQQ is an exchange-traded fund* (ETF) that tracks the Nasdaq 100 Index. It is similar in nature to its brothers SPY and DIA, which track the Standard & Poor's 500 and Dow Jones industrials, respectively. The Qs were launched in March 1999 and are traded on the American and New York stock exchanges. Like the Nasdaq 100, the QQQ is heavily weighted toward technology (just under 70%) and is a market cap­weighted vehicle, rebalanced annually. Its most recent rebalancing occurred in December 2001, and resulted in an increased weighting for health care and biotech, although tech still rules the Q roost.

Why consider a change to the Qs when so many equities and commodities are vying for your capital and trading attention? Or when the Qs' volatility is so low, especially compared to the potential of its underlying equities? My own trading history may provide a few clues.

DECIMALIZATION AND TIME

You may be familiar with the three cardinal rules of real estate sales: "Location, location, and location!" In the same way, while the Qs have numerous trading benefits over individual equities, Qs have three main ones: "Decimalization, decimalization, decimalization." I was once a heavy spread scalper*, but my personal journey to the Qs began in early 2000 when decimalization all but eliminated professional profit spreads and the ability to capture quick eighths and quarters on subtle market turns. Simply put, I experienced a personal "earnings warning" similar to that most market makers experience.

As is often the case in this ever-evolving industry, I was presented with a stark choice: adapt or give up trading. Since I didn't care to go back to my former life as a corporate executive (been there, done that), and since one of the reasons I left that comfortable lot in life to pursue trading in the first place was for the challenge (as in, "be careful what you ask for"), I chose the former.

After some initial hand-wringing, I quickly realized that I needed to put time on my side in a way I never had before, essentially letting time do most of the heavy lifting — a daunting task for an impatient scalper highly protective of his capital. Yet in accepting time as a new partner, I felt it was paramount to trade a general market where time wouldn't become a disadvantage. I preferred to move to a market that was highly liquid and whose movements would be insulated from specific company events as well as manipulative potential. Since I preferred to stay away from the index futures market, my choice was obvious: the QQQ, which at the time was just beginning to be noticed.

LIQUIDITY

It is no exaggeration to say that over the past year, the Qs may very well have become the most liquid trading vehicle, as evidenced by an explosion in volume and traffic among electronic communication networks (ECNs) that facilitate direct and instant trader-to-trader order matching. Despite the unrelenting Nasdaq bear market of the past few years (which has been downright brutal to investors), traders still can't seem to get their fill of technology activity.

While the trading volume of tech stocks, including the underlying components of the QQQ itself, has dwindled over the past year, trading interest in the Qs continues to mount (see Figure 1). You can buy a few thousand shares of the Qs any time during the trading day at a precise amount (to the penny) and then turn the purchase around in a short period of time. If you want to place a large order, it too executes very quickly.

Figure 1: Nasdaq 100 Trust (QQQ). Trader interest is reflected by the increase in volume.

NO HIDDEN SUPPLY, NO MANIPULATION

Have you ever found yourself correctly positioned for a general market move, but your stock just sits there as Goldman Sachs or another market maker sells and sells and sells into the strength? Or have you ever been trapped by the ongoing games on Level II where what appears to be strength actually reflects weakness? The Qs may be your salvation; they can help you shift your focus from trying to interpret street games back to technical analysis.

Earlier, I mentioned that when time became a critical ally in my trading, I needed to find a market less likely to be deliberately influenced by its participants. As an ETF, the QQQ must track its underlying equities, while maintaining a one-to-one relationship with the Nasdaq 100 futures. What is the significance of this?

Unlike stocks and futures, buy and sell orders cannot influence the price of the Qs. This is why the Qs have quickly become the vehicle of choice for many traders who wish to trade in significant amounts without slowing their order execution or affecting perceived market supply and demand. In other words, you can't "move" or "front-run" the QQQ market with order size; the QQQ is a level playing field, 99.9% free of manipulation. And while potential manipulation of the underlying QQQ equities and/or futures market remains, the effect of any equity shenanigans would be diluted in the Qs.

SAY GOODBYE TO THE UPTICK RULE

Given the derivative nature of the Qs and the fact that trade action doesn't influence market price, upticks are not required for short sales (they would normally prevent downward pressure and bear raids on individual equities). Futures trading, of course, provides a similar benefit, with wonderful results for the astute trader. Want to short a strategic and low-risk downtrend continuation trigger? Try that on a stock as it begins its descent, and fills are all but impossible, requiring risky market fades to establish short positions. But there is never an "if" on filling a QQQ short, so the only challenge is to avoid an imprudent momentum chase on the entry.

IMPROVED DIVERSIFICATION & FOCUS

If I had a nickel for every time that my equity-trading friends have told me their tales of trading multiple stocks simultaneously, I'd have a pile of nickels. Diversification, along with volatility pace and opportunity, is among their top reasons for staying with equities. And while diversification has its merits and trading multiple markets does indeed provide diversification, doing so can also result in unfocused trading and weaker profits.

I prefer to simplify, eliminating as many variables as possible to maintain a clear focus on pattern recognition and trade execution. The beauty of trading Qs is that it essentially provides automatic diversification, so that there is no need to cloud the trading mind by managing multiple positions.

Want to trade MSFT? Trade the Qs, and you'll find that 12% of your trade is MSFT. Do you prefer technology, yet want to insulate yourself from company-specific events such as "Enron-itis"? Consider the Qs. But you say you get a thrill from playing the juggling game? Go to Vegas — your odds will be better there. Does trading multiple positions make you "look" better? Last I checked, trading was about income generation, not about looks. Perhaps a sports metaphor will illustrate: in choosing between a layup and a three-pointer, the ultimate objective is to win. Points aren't awarded for style.

YES, BUT. . .

The point, of course, is that top traders care more about risk management than gain potential, while average traders focus only on one side of the investment sword. Greater upside potential also equals greater risk, which for traders still honing their skills, or professionals struggling with performance, is a short-cut to disaster.

I teach new traders by having them focus on the Qs for all of the reasons I've mentioned: no manipulation, no uptick rule, no hidden market-maker supply and demand, and better liquidity than the Nasdaq futures. Simply put, the QQQ has less "noise," and the resulting market simplicity typically results in better focus and performance.

Don Miller is a professional trader. He writes "Don Miller's Trading The QQQs," which appears daily at www.tradingmarkets.com, and he recently launched "Don Miller's QQQ Trading School" at www.donmillerqqq.com.

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