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Welcome to my brand new series of articles on trading a large index like the Dow. The Dow Jones Industrial Average is probably the most popular index that traders, investors, and mums and dads look at. We hear about it every night on the news and read about it in the papers. Out of all the major Indices in the world, the Dow is probably the one watched the most. It consists of 30 large-cap US companies.

The Dow goes by a couple of symbols. Traders often look at the INDU, though this can't be traded. There's the DJX, a cash settled index and also the DIA, otherwise known as the "Diamonds," which is stock settled. For most traders (myself included) and particularly for traders at the beginning of their careers, it's probably best to trade the DIA when wanting to trade the Dow Jones, as its stock settled and the options have high liquidity too.

In this article we look at taking a view on the Dow, for the present and the future, and look at what sort of strategies an option trader could use to support his/her view. Let's first have a look at the Dow from late 2006 until now (October 2009). This period takes us through the all-time high of the Dow, and the whole market crash last year. I will use the DJX on my chart, but each symbol (INDU, DJX or DIA) would look the same.

Chart 1

 

(Click here to enlarge)

You will notice the set of horizontal green lines on the chart. These are Fibonacci Retracement levels. This indicator can be found in ProfitSource under Drawing Tools. The first thing I have done here is encompass the all time high of the DOW at 14,000 (rounded off, and displayed as 140 in the DJX) and the low of the DOW from the market crash at 6,600 (rounded off too, and displayed as 66 in the DJX). The indicator then plots Fibonacci levels between the low (calling it 0%), and the high of 140 (calling it 100% of the range). Up until recently the DOW was sitting on the 38% retracement level, meaning it had retraced 38% of the total range of 140 to 66.

We cover Fibonacci quite extensively in the Interactive Technical Trading class. We learn how to use the various Fibonacci tools, and how to read what they're telling us. At the time of writing, we just completed an ITT class in Melbourne where we went into Fibonacci quite heavily. We can see now that the DOW has left the 38% level and is on its way to 50%. It wouldn't be surprising to see the DOW consolidate around the 50% level as well, but before it gets there, there's potentially an even bigger resistance point in the way - 10,000 on the DOW!

The level of 10,000 (or 100 on the DJX) is a huge psychological level. It wouldn't be surprising to see the DOW hover around the 10,000 level for a while, poking its head above and dipping under, until the market as a collective decided it was going to push through for sure, or actually turn around and go south again.

It could be a fair enough call to suggest either could happen. On one hand, the market has had a very strong bullish run over the past few months and could be due for a pullback, or, on the other hand reaching the 10,000 mark and pushing through could be enough for traders to say "Game on, we are going north!" Personally, I really don't know which way the market is going - in fact, no one knows, but does that matter to us as option traders? Let's now have a look at the market with two possible directions it could head over the next few months.

Chart 2

 

(Click here to enlarge)

On the chart above I've simply drawn two arrows - you don't need to be a great technical analyst to do this, but there is a little thought behind how I've drawn them. You may notice that the down arrowhead is in December, whereas the up arrowhead is in January. I noticed in the chart, that since March of this year the DOW took roughly 4 months to gain roughly 2000 points (or 20 points on the DJX). Therefore I thought if the market continued to head up in its trend, it is a possibility that the DOW could be at roughly 11,000 / 12,000 in approximately 4 or 5 months' time. It may very well take longer because the market has already had a stellar run up. The other thought is that if we are close to a top, and the market turned around, it would probably come down 2000 points a lot faster than it would run up 2000 points. Historically, markets fall faster than they rise. Because of this I drew a line down to roughly the 8500 / 8000 area with a slightly shorter time projection. Very simple actually - that's as much that went into it.

Another way of expressing a view on the market could be, "The trader doesn't think the DOW will be where it is in 4 months' time." There is not an actual price prognosis here, but rather just a view on where the trader doesn't think the market will be. Therefore if the trader doesn't think the market will be where it is now, then the view must imply that it will either be somewhat higher or lower.

Is it possible to put trades on that would be profitable is this prognosis played itself out? You bet! Naturally the trader could theoretically just buy some OTM Calls and Puts - ie, a very wide and long term strangle (please note: this was NOT a trade recommendation, just a concept to understand). However there are much cheaper and more profitable ways to capture this sort of move, in both directions, using Butterflies - in fact, Out-Of-The-Money [OTM] Butterflies. The OTM Butterfly, when constructed in the right way, can be cheaper, more profitable, and actually put time decay on your side once the market starts to move in one of the directions.

In the Masters Interactive Computer Trading class [MICT], most of the second day is spent on OTM Butterflies and their modifications. It's a very in-depth topic, but I will introduce them to our readers in Part 2 of this series.

Manage your trades!

Matt Baker
Trading Tutors 

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Recent Articles by Matt Baker, Optionetics.com.au

• November 16, 2009
  Index Trading: Let's Trade the Dow! Part II
• November 16, 2009
  Options Corner: The Magic of Butterflies, Part VII
• November 9, 2009
  The Magic of Butterflies, Part VI
• November 2, 2009
  Options Corner: The Magic of Butterflies, Part V
• October 14, 2009
  Index Trading - Let's Trade the Dow! Part 1