The Behavior of the DJIA

[Originally posted: Thursday, September 28, 2006 12:24 PM]

The DJIA is the only equity index that I know of that is a simple average instead of a weighted average. For this reason it can behave differently to the other indices due and the agenda of the participants in this market.

There are 30 stocks in the DJIA. They are:

3M Co.
Alcoa Inc.
Altria Group Inc.
American Express Co.
American International Group Inc.
AT&T Inc.
Boeing Co.
Caterpillar Inc.
Citigroup Inc.
Coca-Cola Co.
E.I. DuPont de Nemours & Co.
Exxon Mobil Corp.
General Electric Co.
General Motors Corp.
Hewlett-Packard Co.
Home Depot Inc.
Honeywell International Inc.
Intel Corp.
International Business Machines Corp.
Johnson & Johnson
JPMorgan Chase & Co.
McDonald's Corp.
Merck & Co. Inc.
Microsoft Corp.
Pfizer Inc.
Procter & Gamble Co.
United Technologies Corp.
Verizon Communications Inc.
Wal-Mart Stores Inc.
Walt Disney Co.

A strange thing happened at this point while I was writing the blog. I went to this page to get the components of the DJIA: http://www.djindexes.com/mdsidx/index.cfm?event=showComponentWeights&rptsymbol=DJI&sitemapid=1

I discovered that the index IS weighted - it certainly looks like it from the table. This must be a recent change that I missed so I won't go on about how it is a simple average and come back to that when I've got my facts straight.

I'll move onto the second thing that I was going to say.

I am a fan (at least theoretically) of having a quiver of tools and indicators to use in trading the market and pulling out the appropriate ones at the right time. You use the tool that most often works in this type of market - that's fairly obvious.

One thing that I have not done is run a back test across a market to determine which tools are best at extremes. I doubt that many people have done this because it is not necessarily time well spent.

If you take the futures rollover day which happens 4 times a year, or futures expiration for that matter. Is it worth it to do days worth of testing to isolate small anomalies that occur on those days? Perhaps. But then you also have to ask yourself if you have enough sample data to make your back testing and studying significant. If you study rollover days over the last 10 years you only have 40 trading days of data which equates to 2 calendar months of data. Is that significant enough to draw conclusions from?

So when the market hits extremes have we seen this enough times in the past in enough markets use that data to help us select the tools we need?

I was going to mention this in the last blog post but didn't because I thought that the index had been changed from a price weighted index to a market cap weighted index. I was wrong and it remains a price weighted index.

So how does one manipulate a price weighted index?

You try and move the stock in the price weighted index that you can move the most by absolute value. These will be the stocks with the lowest market capitalisation (it will take less volume to move them) and the highest prices (a small percent move will have a greater price move than a lower priced stock).

So given this information, and assuming that you are a large bank with tons of money, you might take a position in an index future and then try and influence the index by trading the components that most highly favor your direction.

Is this legal?

I don't know, but I would guess that it's not. I don't have that sort of money to move an index so this is an academic curiosity for me. When I do have that sort of money I will revisit this topic and ascertain the legality of doing this before I attempt it.