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A Closer Look At HOLDRs

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Merrill Lynch did traders a big favor with the advent of its sector shares. Known as HOLDRs, Merrill's sector shares total 15. The HOLDRs provide traders with a medium to execute market observations, while at the same time further minimizing non-systematic risk -- something I pursue with passion.

For a complete listing of the HOLDRs as well as individual components, you can check out the following site:

http://www.holdrs.com/holdrs/main/index.asp?Action=Definition

Not all 15 of the sector HOLDRs are equal in terms of liquidity, neither in volume in the underlying nor the options. The following quote sheet displays the 15 sector shares with daily volume totals for today through the time of writing.

HOLDRs Sorted By Volume

The top five most active, Semiconductor, Oil Service, Biotech, Pharma, and Software, are typically the volume leaders by a wide margin. In other words, these five HOLDRs are the most liquid of the bunch and the choice for traders. Liquidity is a risk when absent. For that reason, I choose not to trade any of the HOLDRs outside of the aforementioned five. Whether you choose to trade the Retail HOLDRs, for example, is dependent on your liquidity requirements and risk tolerance.

For stock traders, the HOLDRs offer several benefits. First, they are readily available to borrow for the purposes of establishing short positions. If you've ever tried to put out stock in a fast moving market, you know that it can be difficult to get a good fill. Second, and more importantly, the HOLDRs reduce non-systematic risk associated with individual equities.

Take our recent bullish stance on the Biotechnology Sector. There have been great risks associated with individual equities in the group recently. Protein Design Labs (NASDAQ:PDLI) was a stock that was whacked yesterday. And Myriad Genetics (NASDAQ:MYGN) is getting taken apart today. Those risks could've been removed through employing the Biotech HOLDRs (AMEX:BBH) instead of the individual equity.

For options traders, the HOLDRs hold greater liquidity than options on the sector indexes. Take the Semiconductor Sector for example. The March "around-the-money" open interest in the Semi HOLDRs (AMEX:SMH) totals about 29,000 contracts. In contrast, the March "around-the-money" open interest in the Semiconductor Sector (SOX.X) totals less than 2,000 contracts. Plus, the SMH is much lower priced than the 500-handle SOX.X, which equates to a much lower cost to carry.

My good buddy Austin Passamonte, who is one of the best swing traders in the market today, made an interesting observation concerning the behavior of the HOLDRs options. He noted that the implied volatility is in between a broad-based index such as the Nasdaq-100 (NDX.X or QQQs) and that of an individual stock. In essence, the trading of the HOLDRs options is more responsive than the QQQs options, for example. But you won't get as much movement as you would in an individual stock, which is where the reduction of non-systematic risk comes into play. When you give up some risk, you lose some reward potential. However, I view the HOLDRs options as a happy medium between risk and potential reward.

I'm not associated with Merrill and not trying to sell their HOLDRs. But the next time you read Bailey or I adopt a bias on one of the five aforementioned sectors, consider reducing your risk through using the HOLDRs, either the underlying or options. They are an efficient, liquid alternative to trading sector rotations.

Eric Utley
Option Investor

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