The Dow Jones Industrial Average is made up of 30 of the largest companies in terms of market cap. Because the index represents large companies, the performance of any one of the companies that make up the index can influence the overall stock market.
There aren’t too many things that last forever, especially in a world where technology changes so quickly. So, it’s comforting to know that the Dow Jones Industrial Average is still chugging along. Sure, it may have had a few facelifts since it came into existence in 1896, but it’s still doing the same job—measuring stock market performance.
Almost everyone has heard of the Dow Jones Industrial Average ($DJI) along with other indices such as the Nasdaq Composite (COMP) and the S&P 500 Index (SPX). Countless news outlets blast their closing values, and most everyone pays attention because these indices drive the stock market. And many traders follow the charts of these indices, such as the one in figure 1. If you own a portfolio, it’s likely you have one or more stocks that are part of an index. So, when you hear the Dow Jones Industrial Average closed at a certain level, what does it really mean?
We’ll start with the most-asked question: What is the Dow Jones Industrial Average?
FIGURE 1: WHAT IS THE DOW? The Dow is an index that gives an overall view of the stock markets. It’s a good idea for investors and traders to follow a broad index such as the Dow to help make trading decisions. Here, you see the Dow Jones Industrial Average ($DJI—candlestick) has generally been moving in an uptrend (yellow trendline) for the last year. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
The Dow Jones Industrial Average (herein referred to as “the Dow”) is an index that gives an indication of what’s going on in the market. “It’s a heavily cyclical type of index, so it doesn’t include many of the technology names,” said Shawn Cruz, senior market strategist at TD Ameritrade. “So, in 2020 when we had more of the tech stay-at-home type trades, it wouldn’t have been out of reach to think the Dow was pretty much off to the side. But in 2021, the Dow could be a heavily watched index even though it includes some tech stocks like Apple (AAPL) and Microsoft (MSFT).”
Every index is made up of a set number of weighted stocks. But not all indices are weighted the same, which has brought about differences in opinion about whether the Dow is a true reflection of the performance of the overall stock market. Sure, it’s been around forever and has gained brand recognition, but the stocks in the index and the way the index is weighted does bring up some questions.
The index represents 30 large-cap, dividend-paying stocks. The index is weighted by price, which means higher-priced stocks have a higher weighting than lower-priced stocks when figuring out the average. So even if companies with lower-priced shares have a larger market cap, they’ll have less weighting in the Dow. “As an example, Johnson & Johnson (JNJ) and Amgen (AMGN) stocks have a higher weighting than AAPL, and UnitedHealth Group (UNH) may have a higher weighting than AAPL and MSFT,” Cruz commented.
Short term: Through the lens of a shorter-term strategy, sophisticated option traders might consider selling puts on some of the Dogs. Say ABCD stock made it to the Dogs list and is trading at $53.38. You could sell a 50 put for, say, $2.80, minus transaction costs. If the stock price stays above $53.38 through the expiration date of the options contract, your put would have expired* worthless, and you would have made $280, minus transaction costs. If the stock price goes below $50 prior to expiration, you’ll likely be assigned the shares and end up purchasing them at $50 per share at a time when the current price of the underlying stock is lower.
Long term: A longer-term strategy may involve buying vertical spreads on LEAPS® (Long-term Equity AnticiPation Securities—these are options with nine months or longer to expiration) on the Dogs. Because this is a longer-term strategy, it could tie up your capital for the duration of the trade, which means you may have to sacrifice other opportunities. It can be difficult to close a position before expiration, absorb any profits or losses, and free up capital to take advantage of other opportunities.
In contrast, the Nasdaq-100 Index (NDX)—considered a technology index by many—consists of 100 nonfinancial companies. This index is “capitalization-weighted” (cap-weighted), meaning the component securities are weighted based on market cap (price times the number of shares outstanding). The SPX is also cap-weighted. The influence of this weighting means a handful of larger companies make up most of an index’s total market cap. Not surprisingly, larger-cap stocks can have a significant impact on the index’s movement. So if stocks that rank in the top 10 in terms of market cap happen to move big in a single day, you’ll likely see a noticeable impact in the index’s movement.
The stocks that make up the Dow change as the economy changes. Most of the companies that were included in the original Dow, which at the time was made up of 12 stocks, are either no longer included in the index or no longer around. General Electric (GE), one of the Dow originals, had a long tenure. It lasted as long as 2018, at which time it was replaced by Walgreens Boots Alliance (WBA). Some technology and service companies have also been added to the Dow over time.
All traders should evaluate the overall market before making trading decisions. Should the market move and reporters react, knowing the flow of indices will help sensitize you to which stocks are actually making moves.
Based on earnings reports or other economic data, if you expect a big price change in one of the Dow’s top 10 stocks, you may want to trade in that particular stock or options based on the underlying stock. Another way to gain exposure to Dow stocks is via exchange-traded funds that track the Dow. There are also futures contracts based on the Dow, but these are risky and not suitable for all investors. However, investors can follow the futures contracts such as the E-mini Dow Jones Industrial Average (/YM) before the markets open to get an idea of which direction the market might move when the opening bell rings.
One trading strategy involving Dow stocks that you may have heard of is the “Dogs of the Dow.” Those who use this strategy buy the 10 highest-dividend-yielding Dow stocks at the start of the year and then rebalance at the start of the following year. So, each year they’re investing in dividend stocks. “It’s basically a value-based, income-generating type strategy, which could become interesting when yields are moving around,” mentioned Cruz. If investors believe nondividend paying equities may have topped out, they could consider purchasing equities that offer high-dividend yields. “When yields are high, investing in dividend-yielding stocks, especially when these types of stocks could start seeing a recovery, could become a value-investing type strategy,” Cruz added.
If investors want to invest in stocks specifically focused on the economy firing up again, another avenue to consider is the Dow Jones Transportation Average ($DJT). This includes companies in trucking, rail, airlines, and shipping. For example, in 2021 people are likely to be traveling and going out more, so there’s a chance companies in the transportation space could do well.
It may be counterintuitive, but often only a handful of stocks drive some of the market’s most dramatic moves. Although no strategy guarantees positive returns, being aware of these stocks will take you one step higher on your market awareness ladder.
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*Please note that the Dogs of the Dow stocks are dividend-paying stocks, and if there is an ex-dividend date between the sale date and the expiry date, there is a greater likelihood of early assignment on or shortly after the ex-dividend date. It is not possible to invest directly in an index.
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