Why More And More Traders Are Trading The QQQs, Part I

Do you ever watch the stocks you are trading languish while the rest of the market goes up? Or worse, even drop, contrary to the direction of the index? Ever find some great shorts that don't seem to reach the trigger point, on a day the market goes in the tank?

Perhaps all you need is an insurance policy -- in the form of the Nasdaq 100 Index Tracking Stock (QQQ | Quote | Chart | News | PowerRating), known affectionately as the Q's. With the Q's, you don't need to pick individual stocks, and it is easier to track the 100 stocks that comprise the index, if you choose to trade them (as many traders do) since the institutions track the issues as well. If you are not trading the Q's, you should introduce this vehicle into your trading repertoire. The many advantages of the index tracking stock include:

• It is often easier to anticipate the future direction of the index as a whole than individual stocks
• Mirrors the action of the index, and moves in a similar manner to the Nasdaq 100 futures
• Less capital required to trade than a full-size futures contract
• Unlike individual stocks, the uptick rule does not apply, making shorting them very easy
• Over 70 million shares trade daily on average, making them very liquid

But before we get into the advantages in greater detail, let us first obtain a really good understanding of what the QQQ is.

What is it?

Although the Nasdaq 100 index was formed in 1985, the tracking stock did not begin trading on the American Stock Exchange until March 10, 1999. The index is made up of the 100 largest and most actively trades issues listed on the Nasdaq Stock Market. It reflects the Nasdaq’s largest companies across major industry groups, including computer equipment, software and services, telecommunications, and biotechnology, for example. In order to limit domination of the index by a few large stocks, the index is calculated by using a capitalization weighted method. This capitalization weight distribution is evaluated on a quarterly basis and is rebalanced, if necessary. So what is the QQQ exactly? It is a unit investment trust that contains the same underlying securities that comprise the index itself. It simply trades in the same manner as any common stock and can be traded throughout the session on the AMEX.

Advantages

It is often much easier to track and anticipate the future direction of the Nasdaq 100 or its tracking stock than to sift through the thousands of stocks listed on the three exchanges. For example, take the simple strategy of trading pullbacks within a trend.

Back in March, swing traders were able to catch not one, but two moves of more than 7 points each by simply shorting when the Q's resumed their downtrend after pulling back from their low. This would have required about 30 seconds (if that) of looking at the daily chart to spot these patterns.

Daytraders can also make use of this instrument in their trading, as a simple continuation short below the prior day's bottom price yields a 2 point profit.

No Need To Wait For An Uptick

One of the biggest advantages of trading the Q's as opposed to common stocks is that when entering a short position, the uptick rule does not apply. This means that the tracking stock, and its cousins the Spiders (SPY | Quote | Chart | News | PowerRating) (S&P 500 tracking stock) and the Diamonds (DIA | Quote | Chart | News | PowerRating) (Dow Jones Industrial Average tracking stock) does not have to trade at a higher price before you can get filled on your short position. In this manner, they trade the same as futures contracts, in that when you are short, you are filled at whatever the issue is trading when your short order is executed. This is important, because a fast-moving stock, even when you have called the proper direction, may slide as much as 1 point -- or even more -- before the first trade at a higher price takes place.

How Big Is Your Account?

While some traders choose to trade the stock index futures contracts of the Nasdaq 100, this requires a large amount of capital in one's account. The initial margin on the Nasdaq 100 futures is around $48,000 per contract, while 500 shares of the QQQ would run you in the area of $11,250 using 2-to-1 margin, or less than 25% of the capital outlay. While it is true that the futures offer greater margin, and therefore greater potential return, it should also be remembered that the potential for loss is also multiplied in the same fashion. Traders who are not familiar with trading either futures or e-minis may be more comfortable with trading a vehicle that is more familiar.

Liquidity, Liquidity, Liquidity

The liquidity of this instrument is another great reason to trade the Q's as opposed to the futures or e-mini contracts. With an average daily volume of over 74 million shares, the tracking stock blows away the volume of both the big contract (around 25,000 traded per day) and the e-mini (the average is around 170,000 per day). So what does this mean to you as a trader? What it translates to is for the most part, better fills, since there are more sellers when you buy and vice versa, whereas trading the futures is more likely to be fraught with bigger spreads and worse fills due to the lesser liquidity. Even the e-mini and its electronic matching of buyer and seller, exists in a less liquid environment since there are less contracts changing hands daily.

In conclusion, the QQQ is a very versatile trading instrument that every trader should keep in his or her arsenal for the times when they may have lost their focus, feel that they may have a better grasp of the index than individual issues, or for those who are not able to trade on a full time basis to spot profitable trading opportunities in the short amount of time they have to allow for chart study each evening. The Chicago Board Options Exchange (CBOE) also lists options on the Q's, so there are also strategies to employ in that area.

In Part II of this series, we will go into several different strategies you can use that some of the TradingMarkets contributors utilize in their trading.

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