What is the Dow Jones Industrial Average (DJIA), and Why Does It Matter to Traders at Banks?

Dow Jones Industrial Average Definition: The Dow Jones Industrial Average (DJIA) is a major stock market index that tracks 30 blue-chip companies in the U.S. with consistently stable earnings; these companies are listed on the New York Stock Exchange (NYSE) and Nasdaq exchanges.

The DJIA was originally devised to track the performance of U.S. industrial output, but it now includes companies from most industry sectors, including telecommunications, financials, energy, technology, consumer/retail, and healthcare. It does not include utility and transportation stocks, which are represented in separate indices, such as the S&P 500.

Examples of Dow Jones Industrial Average stocks include Amazon, Apple, Johnson & Johnson, J.P. Morgan, Visa, and Walmart.

The full list as of 2024 is shown below:

The DJIA was created by Charles Dow in 1896 to serve as a proxy for the broader U.S. economy; Charles Dow was the first editor of the Wall Street Journal and a co-founder of Dow Jones & Company.

Initially, the DJIA included 12 stocks (mostly in railroads). In 1928, it expanded to a much broader set of 30 companies.

The Dow Jones Industrial Average is a price-weighted index rather than a market-cap-weighted index.

This means that companies with higher stock prices have a greater influence on the index than companies with lower stock prices, and a big increase or decrease in one company’s share price makes a major impact.

This feature arguably makes the index deceptive because, for example, a company with a market cap of $50 billion and a share price of $50.00 will be less influential than a company with a market cap of $100 billion and a share price of $10.00.

The DJIA is calculated by summing up the prices of the 30 constituent stocks and dividing by the “Dow divisor,” which is adjusted over time as the index changes and companies complete corporate actions such as mergers, acquisitions, divestitures, and dividend issuances.

Traders at banks pay a lot of attention to the DJIA because it’s a reliable indicator of the broader stock market and economy since it includes so many blue-chip companies.

Over time, the movements of the index have mirrored the Wilshire 5000, even though the Wilshire 5000 includes thousands of companies and is market-cap-weighted.

Besides the limited set of companies in the DJIA and its price-weighting mechanism, it is also criticized for including only U.S.-based companies, which means it does not represent the full picture of the global markets.

How Companies Get Selected for the Dow Jones Industrial Average

To be considered for the Dow, a stock must be a non-transportation or non-utility company in the S&P 500.

However, unlike the S&P 500 inclusion criteria, the Dow Jones doesn’t have specific “rules” for which stocks make it – which means inclusion can be arbitrary.

According to S&P, the DJIA uses the following criteria to select companies:

• “While stock selection is not governed by quantitative rules, a stock typically is added only if the company has an excellent reputation, demonstrates sustained growth, and is of interest to a large number of investors.”
• “Since the indexes are price-weighted, the Index Committee evaluates stock price when considering a company for inclusion.”
• “Maintaining adequate sector representation within the index is also a consideration in the selection process for the Dow Jones Industrial Average.”
• “Companies should be incorporated and headquartered in the U.S., and a plurality of revenues should be derived from the U.S.”

A committee of S&P Global and the Wall Street Journal representatives determines DJIA membership.

The representatives evaluate criteria such as stock prices, corporate actions, minimum requirements for market cap, monthly trading volumes, public float, sector classification, and trading volume to float-adjusted market capitalization to decide on the individual stocks.

They keep the selection process confidential, so outsiders never have much insight into it; this is also done to prevent index inclusion speculation from affecting a company’s stock price.

Over time, many companies in the DJIA have been replaced, with Apple famously taking the spot of AT&T in 2015.

Because of the arbitrary selection criteria, quite a few people have dismissed the importance of DJIA. For example, Scott Galloway, a professor at NYU Stern, stated that the DJIA is “totally disarticulated from the underlying economy or the health of our nation.”

The Dow Jones Industrial Average vs. the S&P 500 vs. the Nasdaq

The Nasdaq Composite, S&P 500, and Dow Jones Industrial Average are all indexes that are used to measure market performance, but they differ in three main ways:

• Their composition and their method of weighting stocks;
• The criteria they use to include stocks;
• Their performance.

Here’s a bit more on each key difference:

Composition

The Nasdaq Composite and the S&P 500 cover more companies in different sectors than the Dow.

The Nasdaq Composite has more than 3,000 stocks as constituents, while the S&P 500 consists of 500+ stocks representing large-cap companies traded on American stock exchanges. By contrast, the Dow includes only 30 stocks.

The Nasdaq has a tech focus since over 50% of its companies are in the technology sector, while the Dow and S&P 500 have broader and more diverse companies.

Both Nasdaq and S&P500 are market-cap-weighted indexes, meaning that a $50 billion market cap company has twice the weighting of a $25 billion market cap company.

The Dow is price-weighted, meaning that stock prices rather than market caps determine the weighting of each company.

This can be deceptive because company stock prices are arbitrary; what matters are their Equity Value (market cap or share price * shares outstanding) and Enterprise Value.

Selection Criteria

The S&P 500 uses quantitative and qualitative criteria to determine the index, and a company must meet specific requirements to be included.

These include having a market capitalization of at least $14.6 billion, significant liquidity, and a public float of at least 10% of its shares outstanding.

The Nasdaq uses more quantitative selection criteria, which are outlined here.

Finally, the Dow is more arbitrary and emphasizes qualitative factors (see above) to determine whether a given stock should be included in its index.

Market Performance

Overall index performance is highly dependent on the specific dates you use to measure it, whether you include reinvested dividends, and so on.

However, if we look at their performances between 2000 (right around the time of the dot-com boom and bust) and mid-2024, their performances are as follows:

• S&P 500: +285%
• Nasdaq: +333%
• Dow Jones: +259%

Note that these numbers do not include reinvested dividends, which would improve the S&P and Dow Jones numbers.

The Nasdaq outperformed in this period mostly because Big Tech stocks have been among the best performers for a decade or more.

If you look at the chart, you’ll see that the DJIA didn’t decline nearly as much after 2000 – but it also rose by far less in the 2020s than the S&P or Nasdaq.

Since the Dow includes blue-chip companies, it’s less susceptible to major market downturns such as the dot-com crash and the 2008 financial crisis, which is reflected by its shallower declines in the chart above.

How Traders at Banks Use the Dow Jones Industrial Average

Here are two common ways that professional traders in the sales & trading division of investment banks use the DJIA:

1) Hedging Market Risk – Traders searching for “alpha,” i.e., outperformance over a benchmark index of individual stocks, want to hedge market risk so that they are exposed only to stock-specific risk.

For example, if a trader believes that IBM will outperform the DJIA, they might long IBM’s stock while simultaneously shorting the DJIA via securities linked to the index, such as futures (“shorting” means the trader sells a stock first and then buys it back later, ideally at a lower price).

That way, even if the market tanks, the trader still profits if IBM falls by less than the market.

Another strategy is the protective put, which consists of taking a long position on a Dow Jones-based ETF and purchasing put options on the same ETF.

This one pays off if the Dow Jones goes up; if it goes down, you’re protected because you can exercise the put options to realize a profit.

2) Delta-Neutral Index Options Trading – These groups may hedge directional risk in the market (i.e., the overall stock market goes up or down) by offsetting their delta exposure with E-mini DJIA futures.

If you’ve forgotten the Greeks, “Delta” measures an option’s value with respect to changes in the underlying asset’s price.

So, if a stock price increases, the value of call options on that stock will increase, and vice versa if it decreases. A delta of 0.5 means that for each $1.00 the underlying stock price increases, the call option’s value will increase by $0.50.

Many professionals trade options but do not necessarily want to bet on a specific stock’s price rising or falling – they would rather bet on volatility or other factors.

Since options have both a directional and volatility component (among others), it’s possible to focus on just the volatility and hedge away the directional component via DJIA futures (“futures” are financial contracts that obligate the buyer to purchase an asset at a predetermined future price and date).

For example, if you buy a stock’s call options with a delta of 0.5, you could then short DJIA futures to offset that delta and leave yourself exposed only to the options’ volatility.

In other words, you profit based on the stock price changing by more or less than the market expects, but it doesn’t matter whether the stock goes up or down.

This strategy is known as “delta-neutral trading,” and it lets traders focus on only the components they want to bet on.

They could use a similar strategy in “flow trading,” i.e., when a bank accepts client orders and takes the other side of a client’s position.

For example, if a client has significant long exposure to the DJIA index – via options, stocks, or any other vehicle – and the bank takes the other side of the trade, it will have significant short exposure.

The bank might long an equivalent number of Dow Jones futures to counter this exposure and offset this directional risk.

The bank could then execute the client’s trade, earn commissions from that, and hedge the risk of the market going up or down.