How to Trade With the Dow

The Dow Jones Industrial Average is the best known of all stock indexes.
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Charles Dow began compiling data on the major transportation and industrial companies in the early 19th century. This led, in 1896, to the creation of the Dow Industrial Average and the Dow Transportation Average. These stock indexes have changed many times over the years, but still remain the bellwethers of the U.S. stock market. When people refer to "the Dow," they mean the Dow Jones Industrial Average, sometimes also referred to as the DJIA, made up of the leading 30 industrial growth stocks trading in the market today.

Dogs of the Dow

One hot-shot strategy for trading the DJIA is the Dogs of the Dow. The theory states that if you buy equal amounts of each of the 10 top-yielding DJIA stocks, you will outperform the market. This is a sensible theory because investors, seeking good total return, will buy the highest-yielding dividend-paying stocks. Since many investment funds and individual investors focus on the Dow 30, it stands to reason that demand for the highest-yielding of that group will exceed demand for the other stocks in the group, resulting in an increase in the price of those stocks. The theory calls for making the investment on the first day of each year, selling out the previous 10 holdings while doing so. Historic results prove the theory more often than not.

Technical Analysis

Movement of the Dow mirrors the movement of the general market, so applying technical analysis to the chart of the DJIA is a good way of monitoring the broad market and identifying appropriate times to buy in and sell out of positions -- whether you are trading Dow stocks or other high-quality issues that trade with the general market.

Dow Options on Futures (DJX)

In 1997, the Chicago Board Options Exchange created futures and options based on the DJIA. These securities are used to hedge stock portfolios and to trade the movement of the Dow. Because options do not require delivery of the underlying stocks, they are popular vehicles for day traders. Options are good vehicles to trade, using relatively small amounts of money, because of the high leverage they represent. Buying or selling one DJX option allows you to control one one-hundredth of the total value of the Dow 30, so a small movement can result in significant profits or losses.

Exchange-Traded Funds (ETF)

You can also trade the Dow using ETFs that mirror the makeup of the DJIA. This is a reasonably safe way to trade the Dow because ETFs don't have expiration dates as do options. If your options expire just before the Dow makes the move you have anticipated, you will lose your entire investment. Although ETFs don't present the benefits of leverage found in options, they allow you to hold your position until your trading goal is reached. If the Dow doesn't move as you had expected, the lack of leverage also serves to reduce your losses.

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