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What is Index Trading?
By Larry Potter

Almost everyone has heard about index trading but fewer than 5% of personal traders actually do it. One of the most heavily traded indexes is our very own S&P 500 and it trades hundreds of thousands of contracts every day.

As you know every stock fits somehow into a
sector. For instance DELL is in the overall tech sector, WorldCom is in the Telecom sector etc., inside of every sector is a handful of companies that make, produce, or service something that we can classify. So with Dell, and Gateway and Compaq all in the overall umbrella of technology, they are further boiled down into box makers or in other words computer manufacturers. Well there is an index for the box makers! In fact there are over 700 indexes listed on the various exchanges and each index will have a number of stocks in it that represent a sector. So first, why trade an index?

The reason you would want to trade an entire index is that when a sector is on fire, it is logical that the index that tracks that sector will be doing well also. For instance for the past few weeks we have been pretty hot on the Chip makers like INTC, AMAT, KLAC, PMCS, etc.. and they have done pretty well. But you still had to be a bit selective to find the right ones to buy. (there were chip makers that didn't move at all during the past three weeks) But, when AMAT, and INTC, and KLAC and LSCC were making big moves, what do you think was happening to the Philadelphia Semiconductor Index, the SOX? It was gaining big points! So trading an index gives you the advantage of playing a wide rally without having to pick an individual stock. This is very attractive, and with so many indexes to play, you can often be more right about an actual index going higher than an individual stock in that index. Another for instance: Remember when the oil companies and the drillers were starting to look very attractive? When the price of oil rocketed from 11 to 22 dollars, what do you think was happening to the Chicago oil index, the OIX? It was on fire. So even though you knew oil was in vogue, you may have bought the ABC company and that was one that didn't participate in the move. By buying the index, the overall move in the entire sector was reflected. See?

Index trades are a very good place to watch and see what is happening. Suppose with the recent moves in Biotech companies you had been playing the Biotech index, the BTK? It went from about 200 to over 265 in just a month. So again instead of finding the exact stock to play, playing the overall index would have rewarded you greatly. (in fact the August 210 call options that you could have purchased for 6 1/8 on July 2 are now worth 52 5/8)

One of the really neat things about trading indexes is that there are so many of them. If you like the way the gaming stocks look for the next few months, take a look at the Gaming index, the GAX. Like the real powerhouses of the NASDAQ like CSCO, DELL, MSFT, etc? How about playing the NASDAQ 100, the NDX? You can get as wild as you want as there are indexes that track housing, oil, chips, games, advertising, internet, recreation, sports, basically if you can name it, there is an index for it. (there is even one called the Taiwanese lower subdivision index?!)

So, playing the indexes is something that can be profitable both long and short term. In fact to make it even easier to copy playing an index, the Amex now has a trading stock called Diamonds that you can buy and sell just like a stock and its shares gives you a piece of all the DOW Jones industrials. It trades under the ticker DIA. They are trying to give people an easier way to play an index. I suggest you actually watch some of the real moves that are made in the actual indexes and get familiar with the stocks in that index. If a basket of stocks you really think are going to move higher are in a particular index, it may prove wise to trade that index instead of picking the actual stock.

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