Dow Jones index explained
Before we begin to look at the dow jones futures index, we need to look at the dow jones index itself, and understand a little of the make up of the world’s most prestigious stock index, which provides a short hand way of gauging the daily performance of equity markets in the US in general, and more particularly the performance of the underlying components of the index, of which there are 30 blue chip companies. The reason we need to understand how the index works is very simple – dow jones futures, just like any other future, are a derivative, and in our case they are derivatives of what we call the cash market, the dow jones index, which we see reported each day. The reason it is referred to as the cash market is simply to differentiate the index from the dow jones futures market, and in simple terms is called the cash market as this is where real cash changes hands each day for the purchase and sale of real stocks.
As I mentioned in my introduction, in order to trade dow jones futures successfully, you will need to have two live charts in front of you all the time, one showing the dow jones futures chart, the other showing the dow jones index itself, both running in the same time frame. I will explain more of this later, and before we move on, let me make one thing crystal clear from the start – it is the futures markets that lead the cash markets, not the other way round. The reason for this is very simple. The professional traders will be watching the cash markets closely, and as soon as they see either strength or weakness appearing in the the dow jones index itself, they will immediately begin to positions themselves in the dow jones futures market in anticipation of a major move in the market, which will be reflected in significant changes in the futures volumes as a result. If you understand how the two markets work together, and also how to interpret the volume with the price spread, then you are well on your way to becoming a successful futures trader. To master this technique you will need to understand volume spread analaysis, and I will explain the basic principles here, then it is down to you to practice and improve your chart reading skills, which will allow you to analyse the markets second by second, and see the futures traders as they positions themselves ahead of a move in the cash index. Follow these professional traders as they buy and sell, and you should make money trading the dow jones index. I started with ftse futures, but the principles are identical and you will be surprised and even shocked when you are first able to predict a big move, based on your analysis. The key is the relationship between price and volume, coupled with our chart reading skills. If you see a signal in the cash market, see what the reaction is in the futures market, and if they see it as well, which will be clear by the change in futures volume and an associated and corresponding price move, then you know it is a real move, and worth trading. If the futures markets ignores the signal, then you know it is a false signal and can be ignored. I will explain all you need to know later on, but for now, let’s start with a brief look at the dow jones index, its history and the constituent companies that underpin the index.
The dow jones index was originally compiled by Charles Dow, a financial journalist who first created the Dow Jones Industrial Average ( DJIA) in 1896, which started life with just 12 of the largest US stocks, and as the name suggests was originally set up to measure performance in equities in the industrial and manufacturing sector. It had in fact started life much earlier in 1882, and was not published in the Wall Street Journal until 1896, when the two sectors of industrial stocks and manufacturing stocks were separated. Of the original 12 companies, only one remains, General Electric, with the ticker GE. The index was originally calculated using a simple average of stock prices, adding all stock prices together, and then dividing by 12 – a simple method, but one which left much to be desired! In particular stock splits were a problem for the index, since a 1 for 2 split would double the number of shares, and halve the stock price, although of course there had been no fundamental change in the underlying stock. In the early years this was not a problem as stock splits were rare, but as the markets developed this increasingly highlighted the weakness of the index and the way it was calculated.
In 1916, eight new companies were added to the dow jones index, and later in the 1920′s a further 10 companies were added, bringing the total to 30, which remains the number to this day, and hence the reason the dow jones is often referred to as the Dow 30. With more companies being added, the index needed to be revised in the way it was calculated, as well as to overcome some of the problems outlined above, and as a result, a new method was adopted known as the price weighted method. Now curiously, this method has drawbacks as well, and indeed the dow jones index is one of the few in the world to use this simple method, with most modern indices such as the ftse 100, S&P 500 etc using the market cap.