Option Investor
Educational Article

Trading The Dow Jones Industrial Average Index

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Everyday when the financial news gets reported, the first thing out of any of the commentator's mouth is what the Dow Jones Industrial Average is doing at that time, or where the Dow Jones Industrial closed for the day, if the trading day has ended. Whether the headline is oil prices, tension in the middle east, interest rate hikes or any major market story, it all gets related back to the Dow Jones Industrial Averages being up or down. Even though this index accounts for only 30 stocks within the market place, its popularity among profession traders to neophytes to the stock market is equaled by no other investment term that exist, except for the generic type of "The Market", which ironically, leads many individuals to then ask." What did the market close at today", which as we all have come to know means they is referring to the Dow Jones Industrial Averages. In realizing the popularity of the Dow, as we have come to know it, just as stock options are defined as contracts that give the buyer the right to buy or sell a stock at a stated price for a limited period of time, cash-settled index options give buyers similar rights. However, the underlying asset covered by index options is a not share in a company, but rather, an underlying dollar value equal to the index level multiplied by $100. The utilization of the DJX index is how we will set the tone for today's article. How to effectively incorporate the use the Dow Jones Industrial Average Index in our option trading strategies.

The Dow Jones Industrial Average Index (Symbol DJX) offers traders, and especially newer traders an opportunity to participate in the action of the market without all the perils that trading in individual stock issues usually entail.

Why trade the Dow Jones Industrial Average Index Options?

Simple. When you are trading the DJIA Index options your major concern is centered on universal activities that will influence the overall market, as opposed to news event that will influence individual stock events disportionately. For example. If you were trading an option on a stock like Cisco Systems, IBM, Dell, Microsoft or any high tech company, any news that is negative about that stock will have a larger impact on its performance than, any individual story would have on the DJIA. The DJIA, because it is weighted index, bad and good news on a general market basis will influence the direction of the market more exacting. What I mean by that is, when oil prices, or interests or any general economic news, good or bad, is announced you can be sure that the DJIA will go in the direction that the general news goes in. Bad news, the Dow usually goes down; Good news the Dow usually goes up. Where with an individual stock its performance is usually tied to individual issues within its own company, industry group, earnings or some inherent issue tied directly to its individual company or industry group. However, in addition to that, the individual stock-still gets a general influence from the general market news. For example, even if IBM were to announce a good earnings report, it probably could be easily offset by bad general economic news like a hike in interest rates or bad economic numbers like Employment or GNP. So, if you hear a negative or a positive economic report before the market opens or doing the time when the market is open, you can almost be sure that the DJIA will go in the direction of the news. Positive up, negative news, down. Unfortunately, you have no idea how those national or international economic new events are going to effect your individual stock and option play, because your individual issue, even though it has its own individuality, still is influenced by traders due to general economic news, whether good or bad. So even a great performing stock, can under perform in a generally bad market environment, where as the DJIA or any other index is going to almost directly perform in a consistent manner as the news, Good up, Bad Down. Nothing is more frustrating to a trader then to have the news announce the DJIA is up 75 points and found out your stock is down or found out the Dow is off $75 or more points and your stock that you purchased puts on is unchanged or even worse up for the day. The DJIA gives you a little more logical direction, because it is influenced more so by general news occurrences, because traders are more generally influenced by general news events.

What are some of the advantages of trading the DJIA index?

1. Long Term Leap Option Calls or Puts
If you believe that the market is going to be a great place to be in a year or two the DJIA index LEAP call option could be very profitable for you. The main reason is that you don't have to worry about any individual stock story or earnings report or anything that could affect an individual stock. In a nutshell, you have kind of a diversification by having the DJIA, because it is usually the gauge by which the overall performance of the market is judged. So if you are right about the general market environment your option play in the DJIA is going to be profitable. If on the other hand, you think the market is overbought and you see doom and gloom and interest rates go up to 10% or more and we have double digit inflation, well your DJIA puts are going to be very profitable.

2. Selling Credit Spreads on either side of the market or both sides of the market
You also have the advantage of selling puts spread and call credit spreads on either or both sides of the market to generate income.

Why would I sell DJIA credit spreads over individual stock equity spreads?

Good question! Here's why, unforeseen activities within equity issues. For example a BUY out announcement, a rejected FDA drug, bad earnings reports or any number of things that could happen that could hurt an individual company, and especially a small growth one. When trading DJIA credit spreads you have a lot of historical data that you can use if you are a technical trader. You have a ton of historical data you can rely on if you are a fundamental trader. You can use this trading data and develop a scenario that will allow you to sell not only a credit spread on either side of the market, but on both sides and collect two option premiums from being a writer or puts and calls. (Of course, you could also trade naked on both sides, but I don't recommend putting yourself in that position, even the DJIA has seen days like Black Monday and other major one, two or three day sell offs of tremendous numbers. So the concept of naked isn't something that I positively comment on.

3. You can also utilize other popular indexes like the OEX or SPX (Standard and Poors
100 & 500 Indexes) these indexes are almost as popular as the DJIA.

In essence, the DJIA gives you all the satisfaction of option trading, with a lot less unexpected surprises, which you would get from individual equity trades. Don't get me wrong, equity option trading is great. But if you don't have the ability to diversify a bit, then the DJIA or any other major index is an excellent way to get your feet wet and get some type of consistency in a world where consistency of stock performance can be fleeting dream.

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