In fact, when we talked about the general outlook for the economy, overall growth, the rise and fall of prices and how interest rates and the Federal Reserve play a huge role, you were probably saying to yourself, “Heck, I know a ton of this stuff already!”

That’s great: A solid foundation in economics will serve you quite well when it comes to picking stocks and options.

But before we jump right into looking at big option plays, we have an intermediate step: Researching sectors that have solid promise.

In other words, we begin with economic fundamentals, move to promising sectors, and then take a look at outstanding companies in those sectors. Fundamental investing like this is called “Top-Down” and it looks something like this…

So now that we have a bead on the economy, let’s talk about sectors.

Sectors are sections of the economy that have similar characteristics. They’re really no more than groups of companies that are in the same business.

In other words, if the economy is like the theater, a sector is the orchestra section within the theater. Smaller than the theater itself, but not quite an individual seat yet.

Standard & Poor’s (S&P) — the huge financial data provider and publisher — has things broken down into nine sectors: Consumer Discretionary, Consumer Staples, Energy, Financial, Health Care, Industrial, Materials, Technology and Utilities.

S&P’s nine sectors break down the economy nicely!

There are certainly tons of ways to break down the economy outside of these nine sectors, but I like to use S&Ps sectors for a couple of reasons.

First, they make sense. Take a tour around these nine sectors and you’ll find just about every kind of business represented. From financial powerhouses to utilities and health care, S&Ps sectors are a great place to delve deep into sector research. In fact, all told, these nine sectors represent all of the companies in the S&P 500.

But here’s the bigger reason. Each one of these sectors is represented by an “Exchange Traded Fund” (ETF) called a Select Sector SPDR (Standard & Poor’s Depository Receipt). An ETF is a fund that tracks an index — read: sector — but, unlike a mutual fund, is tradable like a stock.

So if I’m interested in a particular sector, I can actually buy the sector by investing in its corresponding Select Sector SPDR. That’s why in the graphic above, each Select Sector SPDR has a symbol next to its name:  XLF for Financial, XLK for Technology, and XLU for Utilities, and so on.

But that’s not all. Since Select Sector SPDRs trade like stocks, they can also have options attached to them. That’s great for our purposes because if we get interested in an entire sector — and not just a company in that sector — we can make a play on it.

Here’s another reason I like focusing on a sector’s ETF: Since they trade like stocks — and unlike an index — ETFs can reflect actual investor interest in a sector. You can use investor interest gauges — such as volume, buying and other related technical analysis methods — that simply can’t be used on an index.

Next time, we’ll dig right into how to look at sectors, both fundamentally and technically.

Best wishes,
Wayne Burritt
September 15, 2008

Investing in Sector ETFs Using Options was originally featured in the Penny Sleuth.