Trading The QQQ

The advantages

There are at least eight advantages to trading the QQQ rather than individual equities.

1. Diversity. The QQQ is composed of 100 different stocks, so you are well diversified with just one trading vehicle.
2. Liquidity. The QQQ trades an average of 112,645,100 shares daily (50-day average), with greater liquidity than almost any single equity.
3. Volatility. The QQQ is weighted toward high-tech stocks, just like the Nasdaq Composite. This results in considerable volatility (price movement).
4. Periodic review. QQQ components are reviewed periodically, and any that fail to meet the minimum requirements are replaced.
5. Easy shorting. The uptick rule does not apply to shorting the QQQ.
6. Professionally traded. Many professional traders buy and sell the QQQ, making QQQ price action less prone to the investing public's emotions than typical equities price action.
7. Large short interest. The large short interest of 47.16% (due in large part to hedging) may work at times to accentuate price movements.
8. Liquid, inexpensive options. Options on the QQQ are widely traded, liquid, and relatively inexpensive.

Risk factors

Of course, as with any trading instrument, it is possible for investors to lose money by investing in the QQQ. All risk factors should be carefully considered. Here is a brief description of some of these risk factors (they are listed more completely, and in more detail, in the prospectus).

1. Prices fluctuate based on changes in the financial conditions of the companies that make up the QQQ, the values of those stocks, and various market-related factors.
2. The composition and weighting of the stocks that make up the index do change occasionally.
3. You can never be guaranteed dividend payments, since these securities have historically paid relatively low dividends.
4. Trading of the QQQ may be halted at any time if (based on AMEX rules and regulations) trading is inadvisable.
5. Because of the high concentration of technology stocks, the performance of the QQQ may be relatively volatile.
6. The performance of the Nasdaq 100 index will not perfectly match that of the QQQ. This is because transaction costs and expenses are taken into account when calculating returns on the QQQ.

Composition

The major industry groups covered in the index and listed according to their respective capitalization in the index as of December 31, 2003, were as follows:

Computer and office equipment: 31.93%
Computer software/services: 26.33%
Telecommunications: 12.63%
Retail/wholesale trade: 9.79%
Biotechnology: 9.33%
Healthcare: 3.66%
Services: 3.06%
Manufacturing: 2.41%
Transportation: 0.86%

The QQQ consists of 100 stocks. The 10 most heavily weighted components as of September 30, 2003, are as follows:

Stock Shares Value

Microsoft Corp., 72,787,050; $2,022,752,120.
Intel Corp., 44,582,519; $1,226,465,098.
Cisco Systems, Inc., 48,587,903; $949,407,624 .
QUALCOMM Inc., 19,721,464; $779,561,761.
Amgen Inc., 11,766,296; $759,749,733.
Dell Inc., 18,480,572; $617,066,299.
Comcast Corp., 18,574,782; $573,589,568.
eBay Inc., 9,365,697; $501,158,446.
Nextel Communications, Inc., 25,184,034; $495,873,629
InterActiveCorp., 14,764,901; $487,979,978.

The total value of the QQQ is $20,061,689,164 as of January 30, 2004.

Price analysis

Fundamental analysis: For the QQQ, fundamental analysis is usually based on relatively long-term considerations related to business cycle stages, such as changing interest rates and their effects on the QQQ's sectors. Sector analysis is usually restricted to part or all of the five sectors that make up 90.01% of the QQQ's value. Of these, the computer and computer-related sectors are the single most important, so sector fundamental analysis may be restricted to examinations of the computer and related sectors.

Interest rates: Since the QQQ is heavily weighted toward growth stocks that generally do not have strong cash positions, but must finance by borrowing, the QQQ is sensitive to the interest rate aspect of the business cycle. The prospect of higher interest rates is probably what ended the recent prolonged uptrend and has been sending prices down. The experts are confident higher interest rates are coming; the only unknowns are when and how high they will rise. This negative influence continues to be priced into the QQQ's price decline. Technical analysis predicts that once interest rate concerns are fully priced in, QQQ prices can be expected to turn and advance.

Oil prices: Higher oil prices raise concerns about a slowing economy, which in turn can be expected to reduce consumer spending and delay interest rate increases. Therefore, the prospect of high oil prices may work to weaken or strengthen the QQQ, depending on which is seen as more important: consumer spending decreases or delayed interest rate increases. These possible effects are mostly indirect; the QQQ's price is generally not reliably changed on a daily basis by oil's price. But if high oil prices are expected to continue, at least for a while longer, in theory, concerns related to this will be reflected in the QQQ's price, most probably by a decline.

Sector analysis: The computer and related sectors are considered to be relatively healthy and exhibiting modest growth at this time. It is generally believed that due to the recent recession, many organizations have put off equipment modernization, including computer replacement. It appears reasonable to expect that, assuming business generally continues to improve, profits will tend to increase, and in theory this will be reflected in higher QQQ prices.

Geopolitical uncertainty: Geopolitical uncertainty, like all market-related uncertainty, is bearish for QQQ prices. A major terrorist event would probably result in a marked price drop. You can try to protect yourself from geopolitical uncertainty by employing put options, keeping funds available for dollar averaging, and so on.

Technical analysis

Price action trend: The two-year uptrend in QQQ prices peaked in mid-January 2004 at 39 (Figure 1). During the approximately five months since then, the overall price trend has been down. A parabolic lower trendline, signaling termination with a sizable rally, characterized the decline from early February to late March. In fact, the late March low at 34.1 was followed by a strong rally that carried to 37.5 in early April, closing above the prior rally's high of 37.2. The late April rally carried to only 37.25. Its failure to close above 39 signaled lower prices to come, and in fact prices then declined to a recent low of 34.1. They then rallied to 36.6, and are now in decline from there.

Figure 1: Trading the QQQ. The importance of support and resistance levels can be seen in this daily chart.

At present, QQQ prices are in a congestive downtrend, with a downward-sloping upper channel line defined by three pulldowns, and a horizontal lower channel line defined by two pullups.

Chart pattern: The two-month chart has formed the figure of a descending triangle. This is a bearish chart pattern, which is suggestive of lower prices. It suggests prices will eventually break down through the support at 34 (which has previously held five times) and from there descend (at a minimum) the same distance as the difference from the triangle's peak to its base. The peak is at 39, the base at 34; the difference is 5. Therefore prices would theoretically descend to at least 29.

Support: There is good price support at 34, due to the price having turned up near that level five times previously. There is a gap near 34 that tends to draw the price there, and once filled, aids a price advance. The chart pattern, however, provides downside pressure with resistance to the support at 34. The question is, will support or resistance prevail? The methods of technical analysis do not provide an answer. But it is possible to position in advance with these possibilities in mind.

Positioning: In theory, QQQ prices will cycle between the descending upper trendline and the horizontal lower trendline until one or the other is decisively penetrated. Then you would consider a short position on the upper trendline, or a long position on the lower trendline, with protective stops in either case. Should prices penetrate either of the trendlines and then reverse and reenter the price channel, technical analysis suggests that the former trend will likely resume.

Dr. Phillip Duke analyzes and trades the QQQ. He may be contacted at drpduke@wmconnect.com.

Related reading

Chart courtesy of MetaStock, eSignal (data).

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