I personally prefer to trade the S&P 500’s index ETFs because I’m unable to consistently predict which stocks or sectors will outperform the broad index. But some traders and investors have the skill to do so. They’ll use earnings growth and technical indicators to predict which stocks/sectors will outperform. I think it’s a better idea to trade sector ETF’s instead of individual stocks if you think you have the ability to understand individual sectors and stocks.
What are sector ETFs
SPDR created 10 sector ETFs for the S&P 500.
- XLE (energy)
- XLU (utilities)
- XLK (technology)
- XLB (materials)
- XLP (consumer staples)
- XLY (consumer discretionary)
- XLI (industrials)
- XLV (healthcare)
- XLF (financials)
- XLRE (real estate)
These sector ETFs track the performance of individual stock sectors. That way traders and investors can focus on individual sectors instead of just trading an index ETF like SPY.
Here is a pie chart illustrating the 10 sector ETFs.
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It’s important to know the components of each sector when you trade sector ETFs. For example, 21% of XLY (consumer discretionary) is Amazon, so changes in Amazon stock will have a big impact on XLY. 14% of XLK is Apple, so changes in Apple will have a big impact on XLK.
Why it’s easier to trade sector ETFs than individual stocks
The overall stock market index (S&P 500) is easiest to trade. You only have to know about the U.S. economy’s fundamentals, corporate earnings, and big technical indicators. You are either bullish or bearish on the S&P 500.
Individual sectors are harder to trade than the stock market index. Individual economic and political factors will determine which sectors outperform and which sectors underperform. For example, the financials sector tends to outperform when interest rates rise. The real estate sector tends to underperform when interest rates rise. You’ll have to predict interest rates when trading individual sectors. You don’t have to predict interest rates when trading the entire S&P 500’s ETF because you’re not looking for underperformance or outperformance.
Individual sectors are complicated. What happens if the broad stock market is bullish (e.g. the S&P 500 is bullish) but the individual sector is bearish (e.g. real estate sector is bearish)? Should you sell that individual sector? This is confusing because the broad stock market impacts the individual sector. The individual sector might be bearish, but the broad market has a bullish influence on the individual sector.
Stocks add another layer of complexity. The overall stock market impacts individual stocks. This is why they say that “a rising tide lifts all boats”. In addition, the stock’s sector also impacts the individual stock.
This is where you may find a difficult situation. What happens if:
- The broad stock market is bullish
- The sector is bearish
- The individual stock is neutral
Should you buy the stock? As you can see, these 3 layers of analysis conflict with each other. Trading is difficult enough, and adding an additional layer of complexity doesn’t help.
Why trading individual stocks is hard
A lot of random and exogenous events impact individual stocks. You cannot consistently and accurately predict these events before they happen. These events can cause the stock to spike or tank in 1 day. You don’t have to worry about these events if you’re trading the broad index or a sector ETF.
Earnings season doesn’t really impact the broad stock index. The beats and post-earnings surges tend to offset the misses and post-earnings crashes. However, individual earnings reports have a big impact on individual stocks. An individual stock might gap up on an earnings beat or gap down on an earnings miss. It’s extremely hard to trade stocks by guessing earnings.
Here’s an example of Amazon gapping up on a strong earnings report.
If your trading time frame is short, you should trade lighter around earnings season because the market’s percentage move is usually bigger. Remember: the more volatile the market, the smaller your position sizes need to be if you want to keep risk under control.
For example, $SNAP might move an average of 1% in a day. It might fluctuate an average of 3% during earnings season. Reduce your position size by 2/3.
Other unpredictable events can also drive a stock price in the short term. A new product announcement might cause the stock price to spike. An accounting scandal might cause the stock price to tank.
Medium term factors also impact individual stocks but not stock market sectors. For example, a new product might cause sales to rise for a few months, which is a medium term bullish factor for that stock. It is very hard to predict how the company’s sales will perform over a multi-month period.
The good thing about trading sector ETFs is that these events tend to cancel each other out. For example, bad news from Apple might be cancelled out by good news from Google, so the XLK ETF (technology sector) might not be impacted in a meaningful way.