The S&P 500 SPDR (SPY, $113.87) ranks right up there with the Nasdaq-100 Trust (QQQ, $36.09) in both name recognition and trading activity. Although its average trading volume is only about 40% of that of QQQ (about 42 million shares per day compared to 98 million per day during the past three months), the money volume (shares traded times price per share) is far higher for SPY, as SPY costs about three times as much per share.

What is the S&P 500 SPDR?
The S&P 500 SPDR (SPY) is essentially a passively-managed, closed-end mutual fund that allows you to buy and sell the stocks that make up the venerable S&P 500 Index in one fell swoop. The S&P 500 Index is meant to reflect the fluctuations in the value of the largest stocks traded in the United States. This does not mean that the firms are domiciled in the U.S. -- it just means they are traded here. Some of the fund's component shares are ADRs (American Depositary Receipt), which means they represent shares of companies traded on another stock exchange. For a full list of the companies that comprise the S&P 500, please visit the following link:
http://tinyurl.com/h7iv

How is the S&P 500 Computed?
The S&P 500 is a market capitalization-weighted index. This means the percentage of value that any given stock holds in the index varies each day along with the total value of the stock itself. This total weight is determined by the stock's market capitalization (its price multiplied by the number shares outstanding). To understand how this works, let's look at a sample index of two stocks:

Company A has 100 shares outstanding and trades at $10.00 per share. This gives it a market cap of $1,000.00.

Company B has just 10 shares outstanding, but its price is $20 per share, giving it a market cap of $200.00.

For the sake of this example, our imaginary index will consist of just Company A and Company B. We will also assume the index's price is equivalent to its market cap divided by 10, or in this case, 120.00. In this scenario:

Company A accounts for 83.3% of this index.
Company B accounts for 16.7% of the index.

On the following trading day, let's assume Company A rallies to $12.00 per share (a +20% increase in value), giving it a market cap of $1,200.00.

Company B jumps +15% to $23.00 per share. Its market cap is now $230.00.

As a whole, our sample index is now worth 143.00. Yet even though Company B's stock price rallied by more than Company A's in dollar terms ($3 versus $2), because its percentage gain was lower, its weighting in the index fell to 16.1%. Meanwhile, Company A's weighting jumped to 83.9% of the index.

What does this mean to investors and traders?
Because the S&P 500 is a market capitalization-weighted index (similar to the example above), over time the major holdings within that index tend to get bigger and the small tend to get smaller when prices rise (the opposite is true as prices fall). As the larger component stocks gain more of the index's total value in an up market, more and more liquidity flows into these larger stocks (and less into the smaller components). In order to keep pace with the underlying index (over $1 trillion is currently indexed to the S&P 500), fund managers are forced to purchase more of the largest shares to keep pace with their benchmark. (Similarly, as prices fall, they are required to sell more, since these stocks tend to account for a smaller percentage of the fund's value.) The end result of all of this is that a market cap weighted index intensifies rising and falling prices.

Dividends
SPY pays dividends on a semi-annual basis. The fund's management company deducts 0.12% for expenses, but this still puts the yield on SPY near 1.1% (based on current market prices). This is more than what you'd earn in a money market account. However, that 1.1% yield can disappear in one day in lost market value. Therefore, you should not use the stock market as a replacement for income in your portfolio!

Changes to the Index
Standard and Poor's periodically changes the component stocks within its S&P 500 index. Anytime a company is delisted, goes bankrupt or is merged out of existence, S&P will remove the stock from the index and will replace it with another firm. Standard and Poor's also changes the index to reflect what it sees as the most important sectors and industries in the market today. For example, the index was much more heavily weighted in technology stocks in 1999 and 2000 than it is now. As prices have dropped in tech stocks, their weighting in the index has fallen (at one time, the S&P 500 was starting to look a lot like the Nasdaq). Standard and Poor's has been removing technology stocks from the index over the past couple of years and has been replacing them with services and industrial shares. A good long-term market-timing tool might be to wait for tech stocks to reach a very low weighting here, then start loading up on them at that time (just as the record weightings in 2000 provided an excellent sell signal).

Trading SPY
The liquidity in SPY is nothing short of astounding. In fact, it is not uncommon to see the shares "crossed" in the market. A crossed market occurs when the highest bid price (price market participants say they are willing to pay to buy SPY) is above the lowest offer price (price market participants are willing to sell SPY to you). Remember, most stocks and funds typically trade with a bid/offer (sometimes called bid/ask) spread, meaning the offer price is normally higher than the bid price. In a situation where you have a crossed market, however, you could theoretically (in practice, it would be nearly impossible) buy and sell at market prices and still make a profit (excluding commissions).

How can this happen? Remember that SPY trades actively on ECNs (Electronic Communications Networks). Because SPY is very liquid in all these locations, it is entirely possible for the bid on one ECN to be higher than the offer on another for brief moments throughout the day. However, with the multitude of direct access platforms available to retail and institutional investors, a crossed market is not likely to last for long and you will not likely be able to actually execute both sides of a crossed market simultaneously for a profit.

HOW TO MAKE MONEY IN SPY THIS YEAR
The S&P 500 SPDR (SPY, $113.87) is likely to remain range bound through the next several months. The fund has upside potential to as high as $118.00. Meanwhile, the downside potential during that time is to about $107. Traders should find themselves with several opportunities to make good money on the fund's near-term price swings.

I expect SPY to rally through in the very short term through the end of April. However, the fund is not likely to post new highs. Aggressive short-term traders might want to sell SPY short from near $114, but the potential downside is only about 6-7% from there. The better idea will be to buy the fund as prices approach $107, as a +10% rally is likely from there.

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