Brief Summary: An index created to see how 30 of the largest publicly owned companies in the U.S. have traded in a single session in the stock market. The ‘Industrial’ part of the average is largely defunct, as many of the companies compared by the index have no involvement in heavy industry.

Full Overview:  Whenever your favourite news network says in the evening news that “Stocks inched higher today” or “The stock market fell by 100 points”, they’re generally referring to the Dow Jones. The Dow is a major stock index that tracks some of the largest companies in the world, followed by investors and traders around the world.

Here, we’ll cover what the Dow Jones is, how the index is calculated, and how traders and investors can get exposure to the Dow’s performance.

Dow Jones Industrial Average Explained

The Dow Jones Industrial Average, or DJIA, is a stock index that tracks the 30 largest blue-chip companies that trade on the Nasdaq and the New York Stock Exchange. The name Dow Jones originates from its founders, Charles Dow and Edward Jones, who created the index back in 1896 to act as a measure for the broader US economy. It’s the second oldest stock index in the United States after the Dow Jones Transportation Average.

The DJIA index is a price-weighted index that is often referred to as “the Dow.” It’s one of the oldest and most widely followed stock indices in the world that tracks large multinational companies such as the Microsoft Corporation and the Exxon Mobil Corporation.

When the DJIA was first launched, it tracked only 12 industrial companies that were active in sectors such as energy, railroads, and tobacco. When industrial companies grow, this usually means that the economy and industrial production are on a good track as well. To investors, a rising Dow relates to a strong economy and a falling Dow to a weakening economy.

The composition of the Dow Jones Industrial Average is occasionally changed to reflect the true economic conditions of the US and the companies that make up the index. For example, if a company’s market capitalisation falls because of falling stock prices, the company could be removed from the index and replaced by another, more stable company.

How the DJIA is Calculated

The Dow is a price-weighted index in which stocks with higher prices have a greater weight in the value of the index. This means that when a highly-priced stock moves in the market, the change will have a larger impact on the DJIA compared to cheaper stocks.

Initially, the Dow Jones was calculated as a simple arithmetic average, but the calculation method has been changed over time to reflect for mergers, acquisitions, and stock splits, and to create a more robust measure of the broader US economy.

Unlike the S&P 500 which represents the market capitalisation of its constituent companies, the DJIA reflects the sum of all stock prices of its component companies divided by the Dow Divisor. This is a key difference between the S&P 500 and the Dow Jones Industrial Average that every market participant should know about.

The Dow Divisor

Since the DJIA is a price-weighted index, investors are using the Dow Divisor to determine the effect that a one-point move in any of the thirty index components has on the total index value. The value of the DJIA is simply the sum of all stock prices of the companies that make up the index divided by the Dow Divisor.

The Dow Divisor is a constant that is continuously adjusted to account for mergers, stock splits, and dividend payments. The Wall Street Journal manually alters the Dow Divisor to maintain the accuracy of the index. As the market has significantly changed over the years since the DJIA was introduced back in 1896, it’s interesting to track the value of the Dow Divisor: The constant was at 16.67 in 1928, but stood at just 0.147 as of September 2019. Since the Dow Divisor is below 1, this makes it actually a multiplier.

Taking the Dow Divisor from September 2019 of 0.147, if the total sum of prices of all 30 DJIA constituents is 3,605, the Dow Jones Index would have a value of 24,523 (3,605 / 0.147). Every price-change of $1 of any index constituent would lead to a movement of 6.8 in the DJIA ($1 / 0.147).

How the DJIA Changed Over Time

The first change to the DJIA came just three months after the index was launched. Since the Great Depression, the index has been changed a total of 51 times to reflect the broader US economy and account for economic shifts. In 1932, eight stocks within the index were replaced and the Coca-Cola Company and Procter & Gamble Co. were added – two companies that are still constituents of the index in 2020.

The following table shows the annual returns of the DJIA since the 2008 Financial Crisis.

On October 19, 1987, also known as the Black Monday, the DJIA experienced its largest one-day drop at the time, falling a whopping 22.61% during the day. While there were no evident economic reasons for the crash, some analysts say that algorithmic trading may have contributed to the crash.

On September 17, 2001, the DJIA lost around 7.1% on the first trading day following the 9/11 attacks in New York City. Nevertheless, the index regained support soon after and closed the year above the 10,000 mark.

On February 12, 2020, the Dow hit its current all-time high of 29,586, as of March 20, 2020.

In March 2020, the DJIA dropped more than 30% amid the global outbreak of coronavirus, falling below 20,000 for the first time since January 2017.

As of March 2020, the current components of the Dow Jones Industrial Average are shown in the table below. The last change to the index happened on April 02, 2019, when Dow Inc. was added to the index.

Investors who are interested in investing in the Dow have multiple options at their disposal. Popular choices include investing in index funds, options, and futures contracts.

How to Invest in the Dow

ETFs

An easy way to invest in the Dow is to buy an exchange-traded fund that tracks the index. Some ETFs are designed to replicate the performance of the Dow by creating a portfolio with the same stocks as the index and in the same proportions.

Some popular ETFs also use leverage to magnify the potential returns for investors, while others utilise short-selling strategies to profit in periods when the Dow is falling. Popular ETFs that track the DJIA include:

SPDR Dow Jones Industrial Average ETF (DIA) – This is an ETF that doesn’t use leverage, which reduces potential profits but also caps losses for investors. The fund has a trailing one-year performance of 3.9% and an annual dividend yield of 2.30% (as of March 2020). Investors who’re willing to invest in this ETF can do so with an expense ratio of only 0.16%.

ProShares Ultra Dow30 (DDM) – If you’re a bullish investor who wants to earn two times the daily performance of the DJIA, then this leveraged ETF from ProShares might be a good option for you. The fund invests in stocks from the index, but also in futures contracts, SWAP agreements, and money market instruments to beat the performance of the DJIA. However, the fund’s expense ratio is a bit higher and stands at 0.95%.

Trading the Dow Jones Industrial Average Traders who look to speculate on short-term movements in the DJIA should consider trading with CFDs. Contracts for Difference (CFDs) are derivative contracts that are designed to track an underlying financial instrument, in this case, the constituents of the Dow. CFDs are perhaps the most popular trading instrument of retail traders, as they offer trading on relatively high leverage (watch your risk!) and also allow for short-selling.

My popular trading strategy for trading the DJIA is to wait for pullbacks to important daily support levels. Since the DJIA has an overall tendency to rise over time, buying at pullbacks allows traders to enter at a low price and ride the overall uptrend.

During longer-term downtrends, traders can use the same pullback strategy. In this case, look to sell pullbacks to important daily resistance levels.

Your stop-loss orders should be placed just below the support (during uptrends) and just above the resistance (during downtrends). Don’t forget to add a few points of leeway to your stop-loss levels to avoid getting stopped out on intraday market noise. As a take-profit, you could use either a recent high or apply a trailing stop to ride the trend as long as it lasts.

Key Takeaways

The Dow Jones Industrial Average is a stock index that tracks the 30 largest blue-chip companies in the United States

The index was founded by Charles Dow and his partner Edward Jones back in 1896.

Unlike the S&P 500 that tracks the 500 largest companies by market capitalisation, the Dow reflects the sum of its constituents’ stock prices divided by the Dow Divisor.

Investors who want to invest in the DJIA can do so by buying ETFs, options, or futures contracts. The easiest way is to buy ETFs that track the performance of the DJIA, such as the SPDR Dow Jones Industrial Average ETF (non-leveraged) and the ProShares Ultra Dow30 (leveraged).

Traders looking for shorter-term speculative opportunities usually trade with CFDs that offer higher leverage and short-selling. A popular strategy includes buying pullbacks to major support levels during uptrends, and to sell pullbacks to major resistance levels during downtrends. 

Final Words

The Dow Jones Industrial Average (DJIA) is one of the oldest stock indexes in the world that tracks the largest blue-chip companies in the US. The component companies of the DJIA trade either on the NYSE or the Nasdaq and are carefully chosen to represent the broader US economy. When news networks say that the stock market rose or fell for the day, they’re generally referring to the performance of the Dow.