Dow Trading: How Reliable Is the Dow Jones Industrial Average?

Dow trading, or trading on the stock market by relying on the Dow Jones Industrial Average, has had its supporters and its critics. The Dow Jones has been around since the 1800s and has influenced almost all aspects of the financial markets, including day trading, overnight trading, option trading and other forms of investments. To get a better understanding of how this philosophy works, read on.

What is the Dow Jones?

The Dow Jones Industrial Average, or simply the Dow, is one of the types of stock market indices that gauge the performance of the industrial sector of the United States stock market. It was developed by Charles Dow, former editor of the "Wall Street Journal."

The Dow average is made up of 30 of the largest (and supposedly) most influential public companies in the U.S. It is calculated by summing up the prices of the 30 companies' stocks, with the product divided by the Dow Divisor or the number of component companies. In cases of splits, spin-offs or other structural changes, the divisor is adjusted to prevent such changes from affecting the numerical value of the average.

Component companies

When the Dow was launched on May 1896, it was comprised of 12 stocks from the 12 biggest American companies. Among the original twelve, only General Electric has remained part of the index in the 21st century. GE is joined by big-name corporations such as, Coca-Cola, IBM, Microsoft, Pfizer, Walt Disney, Walmart and Boeing among others.

Debate on reliability

There are a number of market experts who had argued that the Dow Industrial is not a very reliable representation of the performance of the stock market. One of the arguments put forward against the Dow is that it is a price-weighted average, which means that it gives more power of influence to higher-priced stocks. This supposedly creates a situation wherein a lower-priced stock experiencing a larger percentage change can be negated by a decrease of the same amount in a higher-priced stock.

Another criticism leveled against the Dow is that not all of the 30 companies open at the same time in the morning. When this occurs, the opening price of the average is determined by the price of the stocks that opened first and the closing price of the remaining stocks from the previous day of trading. This, some market observers have argued, makes the average inaccurate.

Despite numerous debates on its reliability, Dow trading has stood the test of time. It remains one of the most cited market indices and there's no denying that it did make a lot of money for a number of investors who prefer to rely on its numbers.