Trading the Transformed Nasdaq 100

In late 1999, America had fallen in love with the technology sector. You could overhear investors at the airport, in restaurants, or at the gym talking about popular stocks like Oracle (ORCL Quote), Intel (INTC Quote) and Microsoft (MSFT Quote). At the same time, the American Stock Exchange launched trading in the Nasdaq 100 Trust (QQQ Quote), an option that quickly became among the most actively traded contracts.

The QQQ became a means of participating in the entire technology sector. Today, while you seldom hear people boast of owning the big major tech names, QQQ options are still among the most actively traded. However, the nature of the contract has changed dramatically over the past three-and-a-half years, and it's no longer a pure play on technology.

The QQQ is actually a tracking stock designed to equal 1/40th of the value of the Nasdaq 100 Index. For instance, on Feb. 27, when the Nasdaq 100 was quoted at 1000, the QQQ was trading for $25, or 1/40th of 1000. The QQQ is really a fund that allows investors to buy all the stocks in the Nasdaq 100 in just one share.

While the QQQ has been a favorite among options traders for more than three years, the makeup of the Nasdaq 100 has changed. The Nasdaq 100 is computed by adding together the market values (price multiplied by shares outstanding) of the index's components. Then, an index value is computed using a divisor. The capitalization-weighted method has been one of the more common methods of constructing an index through the years. Indices such as the S&P 500, the S&P 100 and the Philadelphia Stock Exchange Gold Mining Index are examples of cap-weighted indices.

To illustrate how the cap-weighted method determines the make-up of the Nasdaq 100, consider the top 20 stocks in the index today. The top two are Microsoft and Intel. Together, they represent 16.5% of the Nasdaq 100. That means those two stocks determine 16.5% of the Nasdaq 100's price movements. The top 20 stocks represent 58.2% of the index. Therefore, a large percentage of the index's moves are due to the price changes of a relatively small number of stocks. Cap-weighted indices are sometimes criticized for the fact that they give greater weight to a relatively small number of large stocks.

Now think back to October 1999. Of the top 20 stocks, 19 were technology -- and the other was Amgen (AMGN Quote), a biotech. In addition, some stocks that were among the top 20 three-and-a-half years ago have since fallen sharply in rank.

For example, Sun Microsystems (SUNW Quote), which was the sixth-largest, now ranks 51st, and Yahoo! (YHOO Quote), which was the 10th-largest, is now 46th. Some companies like WorldCom and Global Crossing have been ousted from the Nasdaq 100 altogether.

In short, remember that like the Nasdaq 100 itself, the QQQ has a vastly different look today than it did in 1999. It's no longer a pure play on technology. Instead, retail, biotechnology and other nontech groups play an important role in determining the day-to-day price movements.