Dow Jones Trading: How to Trade The Dow Jones Index

2023.01.20 2023.01.20
Dow Jones Trading

Artem Shashkovhttps://www.litefinance.org/blog/authors/artem-shashkov/

Dow Jones Industrial Average (DJIA) is an index that represents a collective image of American businesses with a large capitalization. Investing in it seems secure due to its long historical growth – all the participating companies have had the status of the most successful enterprises at one time.‎ However, the index is not a holy grail that guarantees profit.

‎In this article we will look in detail at the Dow Jones index, its derivatives and peculiarities of investing in it.

What is Dow Jones Index

Ticker: #YM.

Current price: 1 YM = 33 365.7 USD.

Composition: share prices of the 30 largest US companies. At the moment, the calculation formula offsets the effect of a share split in a particular company.

Main trading platforms: NASDAQ and NYSE exchanges. Derivatives for the index are also traded on the CME and CBOT exchanges.

Leverage: 1:100.

Margin: 1%.

Maximum trade volume: 100 lots (100 CFDs, each equivalent to the current index price).

Lot size: equal to the market price of the Dow Jones index.

The index includes shares of the following companies:

How To Trade Dow Jones Index

A trader cannot buy the Dow Jones index in the traditional sense. The index itself isn’t available for trading and investing, only its derivatives, such as CFDs, futures and options.

YM CFD

YM CFD is one of the derivatives of the Dow Jones index. This is a contract for difference, which is similar to a futures contract.

The instrument is demanding on the size of the deposit: the minimum trade volume is 1 lot. To ensure it, about $35 will be reserved on the trader’s account.

The instrument is traded 23 hours a day. The Dow Jones CFD chart is equivalent to the chart of the underlying asset.

Index options

Index options provide traders with the ability to use the Dow Jones index call and put options. In their classic form, they are traded on the Chicago Board Options Exchange (CBOT). They are bets on price movement in the future: call options are for betting on growth, while put options are for betting on decline.

You can earn on a call option if the price is higher than the determined value at a certain point in the future specified in the terms of the option. A put option will give a profit under the opposite conditions: if the price is below a given value after a certain time.

The value of an index option is approximately 1/100 of the underlying value of the Dow Jones index. It has a narrow spread – up to 1 price point. The instrument is popular among intraday traders as there is a commission fee for position rollover.

Index futures

Dow Jones index futures is a futures contract with the Dow Jones index as the underlying asset. It allows traders to carry out buy and sell transactions. It is traded on the stock market, so traders and investors can access information about trading volumes.

Main trading platform: Chicago Mercantile Exchange (CME). The minimum contract price change (1 tick) is equivalent to $5.

Index futures characteristics:

• smoother price movements in comparison with the shares of each individual company;

• highly liquid instrument that has a narrow spread as a result;

• spread includes rollover fees.

Therefore, the index futures are suitable for both long-term and short-term trading.

What moves the Dow Jones index’s price?

The Dow Jones index is influenced by both macroeconomic factors and the state of the US economy. Long-term trading should be based more on the analysis of the global economic situation, while shorter trades should rely on local economic changes.

1. Economic events

DJIA is sensitive to the situation on the world stage. Fruitful economic cooperation between the US and other large economies, new trade alliances and a stable political situation contribute to the positive dynamics of the Dow Jones index.

The situation inside the country is also relevant: signs of a healthy US economy such as low interest rates, low inflation, high labor productivity, economic development within (or better than) predicted values contribute to the growth of the Dow Jones.

2. US dollar exchange rate

The Dow Jones index has an inverse correlation with the US currency. The increase in the index coincides with the weakening of the US dollar, and the decline of the DJIA correlates with the strengthening of the dollar.

3. News

The future value of the Dow Jones index is most influenced by important news related to the US economy, including meetings of the US Federal Open Market Committee (FOMC), unemployment reports (NFP, Non-Farm Payrolls), Consumer Price Index (CPI).

In the short term, the release of such news increases the volatility of the index price. In the medium term, the news has a positive impact on the Dow Jones if the actual values are equal to or better than the forecast.

4. Earnings reports

DJIA member companies publish quarterly earnings reports.

Here is the Coca-Cola report from their official website:

The growth of the company’s earnings usually motivates traders to invest in its securities, since it promises good dividends or warrants in the future. The increase in demand from investors contributes to the growth of equity instruments of the company, which has a positive effect on the price dynamics of the Dow Jones index. A decrease or stagnation in the earnings of these companies negatively affects the index.

5. Value of individual companies’ shares

Since the DJIA is a composite instrument, its price dynamics depend on the value of the shares of participating companies. The index will rise if the growth in the prices of some shares exceeds the decline in the prices of others. Expensive stocks have the greatest impact, since fluctuations in their prices have a greater impact than that of the cheaper ones.

Steps to Start Trading Dow Jones

Proper investing in the Dow Jones begins with understanding each steps of the process. By following them, the investor can trade in a systematic way. A negligent attitude to even one of the four steps can destroy the results of diligent observance of the other three and obliterate the investment potential.

1. Open a brokerage account

Do your own analysis of the brokerage companies that list Dow Jones among their instruments. In my opinion, priority should be given to time-tested brokers who have been providing services for at least 10 years. Next, pay attention to how broker representatives communicate with clients online – this will save you a lot of trouble. Finally, carefully examine the trading conditions:

• types and amount of commissions;

• margin requirements for trading instruments;

• minimum deposit;

• swap;

• any other parameters that are important to you personally.

Choose the conditions that suit your experience, goals and deposit.

Such thorough analysis will reduce your risks, which means you will increase the potential of your investment.

Next, open a brokerage account and deposit the required amount. If you are new to investing, you can start without investing real money and practice on a demo account.

2. Select a futures trading strategy

The second step before investing is the analysis and testing of various trading strategies. You will need a strategy to make decisions about opening and closing trades. It is recommended to backtest several diverse trading strategies (short/medium/long-term, trend/flat, indicator/non-indicator, etc.).

An example of the FxNuke indicator strategy in the Dow Jones CFD chart:

An example of a non-indicator marking of price zones for entry in the Dow Jones CFD chart:

Select the most profitable strategies based on the test results. Try investing with the most convenient strategy that you understand best.

If you select the most profitable but inconvenient trading strategy, you’re increasing the so-called execution risk. The inconvenience has a negative effect on your discipline in making trading decisions, which makes errors more probable.

3. Buying

In order to make money on the growth of the DJIA, you need to place a buy order. The main types include:

• Buy limit. Pending order. This type of order is used to buy Dow Jones at below market price. You set the desired price value. If the market price drops to this value, the order will be executed.

• Buy stop. This is also a pending order that allows you to buy an instrument at a price higher than the market price. You can use it if you are waiting, for example, for an impulse growth and want to enter after it. The trade will be executed if the price rises to the value you set.

• Market buy order. This order buys the asset at the current market price.

Below is an example of a pending order. Buy limit is set if your desired purchase price is below the market price, Buy stop – if it is higher.

This is an example of a market buy order. The execution price will be equal to the market price.

You can also earn when the price of the DJIA is declining. In this case, you need a ‎short position, which is opened by sell orders:

• Sell limit. This is a pending order to buy at a price higher than the market price.

• Sell stop. This is a pending order that allows you to sell at a price below the market price if you expect downward price momentum.

• Market sell order. This order sells the instrument at the current market price.

Sell limit is used to set a price higher than the market one. Sell stop sets the price lower than the market price:

Here is an example of a market sell order:

For short-term trades, limit orders are more suitable. Although sometimes the market will leave you behind, which will reduce the risk and thus increase the potential profit of your trades.

The second general recommendation is don’t try to catch up with the price. A trade opened too late means betraying your risk management rules in exchange for groundless hope. It may turn out to be unprofitable, which means that the losses will be greater.

Only buy the index according to the rules of your trading (or investment) strategy. Using the wrong type of orders will have a negative effect on the results. Either you will have few trades, for example, if you use Buy limit instead of Buy stop, or the size of profitable trades will be less than necessary, for example, market execution instead of Buy limit.

Another investment option is ETFs. These are exchange-traded mutual funds based on the Dow Jones index. In other words, it’s a portfolio of shares of companies included in the DJIA. A share in such a portfolio is called a unit.

This type of investment is several times cheaper than directly buying shares of each company included in the index, since the value of 1 share can be around $1. At the same time, by buying 1 share, the investor becomes a shareholder of all companies included in Dow Jones. Just as with stocks, shareholders get dividends.

Chart of SPDR Dow Jones Industrial Average ETF Trust (DIA). This is an ETF that follows the Dow Jones index:

When selecting ETFs, look at their returns against DJIA’s: the closer they are, the better. If there are discrepancies, even for the better, they can happen in the future but in the opposite direction.

4. Closing

Positions are closed in the same way for traders and investors: by placing an order opposite to the direction of your trade.

You can either exit here and now at the current market price, or place a pending order with the desired closing price. Such an order will be executed only if the price can reach it.

If you are investing for the long term, you should look for changes in fundamentals that increase the likelihood of the price moving against your position. If you are more of a trader, clear signs of a reversal can be tracked through price chart analysis. They may include:

A general recommendation is to avoid trying to take advantage of the full potential of the movement. The primary goal of traders and investors is to earn rather than sitting through a trend from start to finish.

Before opening a trade, you need to understand your cue for closing the position according to your trading strategy or investment plan.

Dow Jones trading strategies

The best time to buy the Dow Jones depends on whether you are a trader or an investor, and on how long you plan to hold the position open. With short-term investments the entry point is more important, while longer positions provide more ‎freedom in this regard. In the case of Dow Jones trading, the entry needs to provide the potential profit to loss ratio specified in your strategy, for example, 2/1. In the case of investing, you can enter anywhere, since you plan to exit when the ‎fundamental picture‎ changes rather than at a predetermined price.

Study charts and price action

Monitoring price charts in the trading platform is inevitable for almost any trader. This process generates new trading ideas for market entry and exit points. Investors will also benefit from looking at the price action chart to understand their diversity. In some periods, the price can quickly make large movements, and in others it will move slowly or fluctuate in a range.

Timeframes for analyzing the current market should be selected depending on the investment horizon. For example, there is no point in analyzing intraday timeframes when investing or in looking at monthly charts for intraday traders.

To find entry points based on price movements, traders can take a closer look at Price Action patterns and the Auction Market theory. To understand the basics, I recommend the CBOT guide on this topic. Investors can also benefit from looking at the Dow theory.

I will not give particular recommendations since each trader and investor has their own individual approach.

Use technical analysis and indicators

Technical analysis is a broad term. It is based on the idea of recurrent price movements. If the price has behaved in a certain way in the past, it will do so again in the future.

The basic tools of technical analysis are trend and horizontal lines. With the help of trend lines, you can connect the lows and highs of price movements and trade on the rebound from the channel boundaries or their breakout:

The horizontal lines are called levels. They work similarly to trend lines: rebounds or breakouts.

There are quite a few technical analysis tools, so look for those that you feel comfortable using.

If you have trouble analyzing the price chart, you can use indicators. The main categories are trend indicators and ‎oscillators‎.

Trend indicators (Moving Average, Parabolic Sar) are used to determine the direction of the trade, and oscillators (RSI, CCI and others) show the moment when price movement in the expected direction is more likely. This will allow you to be more precise and set a shorter stop loss.

Technical analysis tools and indicators can be used on both small and large timeframes, so they are applicable for both trading and investment purposes.

Look for trading signals

Trading signals are mostly based on the readings of various indicators. They are more of an analytical tool. In my opinion, the signals will suit investors who are not as attached to the profit/risk ratio as traders. They are less appropriate in trading, since your trading strategy may not be based on indicators used for signals and recommendations.

Follow industry news

Both traders and investors will benefit from paying attention to global news, as their impact on the price is quite high. However, news analysis in trading and investing is slightly different.

One analysis option for traders is to keep track of the economic calendar for the current trading day. Since the Dow Jones is made up of US stocks, the most relevant news will be related to the US. Usually news affects the price in the medium and long term. Based on this, daily news analysis will be relevant for swing traders holding open positions for more than a few days. When intraday trading, it is recommended not to trade the Dow Jones index 15 minutes before and after the release of important news, as there is a strong surge in volatility and wider spreads.

Summary

The Dow Jones Industrial Average is the world’s oldest stock index composed of the 30 largest US companies from various economic sectors. Futures, options or CFDs are better suited for short- and medium-term trading, while ETFs based on the Dow Jones index are better for investing. Trading is most active during the American session, as liquidity and volatility are at the highest.

Trading futures and Dow Jones CFDs will require a substantial deposit due to the high price of the index itself and, as a result, the significant amount of the security reserved for an open trade.

The index is an excellent option for long-term investments: a positive trend has been observed over the past 20 years. During this period, there were three significant drops:

• December 1999 – September 2002 – by 33% (from $11,522 to $7,701);

• August 2007 – March 2009 – by 48% (from $13,895 to $7,223);

• February 2020 – April 2020 – by 32% (from $29,398 to $21,052).

After all three corrections, the index recovered and continued to grow. It’s currently trading at 33 365.7 USD.

Price chart of YM in real time mode