How to Do Sector Analysis

I’m sometimes asked by a student trader how to do sector analysis in your trading. This is a broad topic and there are many, many different ways to skin this cat. Lately, I’ve been using it in a very specific way. Let’s first talk about sector analysis, meaning how I use it, and then a sector analysis example or two.

Sector Analysis Meaning

This is simple and straightforward. Market watchers group the stocks (or more accurately, companies) in the stock market into the industry or sector they are in. It’s a way to organize the stock market. And it makes it easier to relate value among similar companies.

This, according to CNBC, is how the market is commonly divided up: financials, health, real estate, consumer discretionary, utilities, technology, materials, industrials, energy, communication services and consumer staples. (See chart, courtesy of CNBC, prices not current.)

sector
Why Sector Analysis?

For one, at its most basic level, this is a way to see which sectors are doing well. And in fact, a way to further simplify this is basically to divide the market into two parts: growth stocks and cyclicals. I’ve had many a discussion on Bloomberg TV talking about which of those was in favor at the time. Generally, these talks are common when interest rates are changing because low rates are great for growth companies; and when rates go higher, cyclicals tend to rise in share price.

That said, the more specific sectors mentioned above each are benefited or hurt by interest rates and other macroeconomic factors. And each has its own sort of “market personality.” And thus, many ETF traders will look toward what is changing in the economy to switch in and out of different sector ETFs to benefit from the current macroeconomic landscape.

But, for me, I’ve taken to a further use, which I landed upon through tightening up our analysis for Credit Spread Genius trades.

When I’m analyzing a credit spread within this new MTM system, in addition to technicals and volatility considerations, I’ll look at how a stock fares within its own sector. By that I mean if I’m considering a put credit spread, for example, I want to have reason to believe the stock won’t fall too much during the life of the option trade. So, I look to see if there’s support and that no “volatility events” like earnings are imminent. But then I’ll look toward the sector to see if it gives me reason to believe the stock might have some buoyancy. Let me show you what I mean.

Sector Analysis Example

On August 16, Schlumberger (SLB) popped up on Credit Spread Genius as having a huge number of 30-32.5 put credit spreads trading. I went and did my technical analysis and the trade looked good. No earnings scheduled to come out—also good. The volatility analysis passed the test. Perfect.

So, I compared where SLB stock price was relative to its peers—a.k.a. its sector. And here’s what I found…

sector

The energy sector, as measured by the Select Sector SPDR Trust Energy ETF (XLE), is shown by the blue line in this chart (courtesy of TD Ameritrade). It was holding pretty steady, even rising at that time (date shown by yellow arrow). But SLB stock (as shown by the candles) never really recovered quite as strongly from the June route a couple of months earlier. SLB was lagging behind its peers. This helped make the case for the put credit spread. Why?

The premise of this analysis is sort of the “rising tide lifts all ships” philosophy. When economic conditions are good for an industry, it helps all companies within that sector. But there’s a lot of noise in the market. A way to restate that from an academic perspective is that “the market isn’t strongly efficient.” So, it’s possible SLB just didn’t seem to catch the wind in the sails that many of the other stocks in the sector did. Possibly for no good reason. The end result of that premise being SLB should rise to catch up to its peers—or, more importantly, at least not fall any more.

As far as the relative importance of sector analysis in my Credit Spread Genius analysis (or any similar use), I’d put it as an “extra edge” to improve the trade. It’s not necessarily the key to the system; but any great trading system is great because it puts several factors on the trader’s side—several sources for edge.

In this case, the trade hitting the scanner is a key factor. The technical analysis of the system and verifying there is not an earnings announcement planned prior to the expiration date of the options being analyzed are the most important factors. But we get an extra edge with sector analysis. Thus, doing this sort of study on all trades like these can end up having a positive impact on the bottom line in the long run.

John KmiecikJohn Kmiecik
Senior Options InstructorSenior Options InstructorDan Passarelli
Founder and President
Market Taker Mentoring, Inc.

Leave a Reply

Your email address will not be published.