The dollar index is one of the most popular currency indices in the world. Today we will look at tips and strategies for using the dollar index in trading.
What is the dollar index?
The US Dollar Index is the most widely known currency index and is traded on exchanges under either the ticker symbol USDX or the ticker symbol DXY. It has been around since 1973, when it originally had a value of 100.
The dollar index became a very useful benchmark for the dollar after the Bretton Woods system of fixed exchange rates began to collapse and Nixon unilaterally stopped converting the US dollar into gold in August 1971.
The basket used to calculate the value of the US dollar index was changed only once after the euro replaced several European currencies in 1999.
The dollar index measures the value of the US dollar against a basket of foreign currencies. These are the US trading partners, namely the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc.
Because it is an index, the Dollar Index works similar to the FTSE 100 or S&P500, but rather than being a barometer for the share market, it shows the relative strength of the US dollar. The index is maintained and published by the world's largest derivatives market operator, Intercontinental Exchange Inc (ICE), and is calculated every 15 seconds.
Here is the relative weight of each of the currencies included in the index:
- Euro – 57.6%
- Japanese yen – 13.6%
- British pound – 11.9%
- Canadian dollar – 9.1%
- Swedish krona – 4.2%
- Swiss franc – 3.6%
Many traders and economists believe that the US Dollar Index basket should be updated to reflect the fact that the United States now does more trade with countries such as China, South Korea, Mexico and Brazil and trades less with such countries like Switzerland and Sweden.
The US dollar is a global reserve currency that is widely traded and attracts interest from traders around the world. This currency accounts for 88% of trades in the forex market, according to a survey by the Bank of Central Reports (BIS).
The US dollar has a rather unique feature in that it tends to rise during times of uncertainty in global markets, as well as during times of growth in the American economy. As a result, the dollar forms established trends that experienced traders can take advantage of.
Dollar Index futures are traded on the Intercontinental Exchange (ICE) 21 hours a day and can be traded through many forex and CFD brokers. Trading hours are currently 03:00 – 24:00 Moscow time.
The smiling dollar theory
The smiling dollar theory was first observed by Stephen Jen, a former currency strategist and economist at Morgan Stanley. He tried to explain why the US dollar strengthens during periods when the US economy is thriving, as well as during periods when global economic conditions deteriorate. These trends resemble a smile and occur in three stages, as shown in the graph below:
Stage 1: Fear pushes investors towards the less risky US dollar.
When investors are risk-averse, they often turn to safe haven assets such as gold, or in this case, the US dollar. A sharp increase in purchases in dollars leads to an increase in the dollar exchange rate.
Stage 2: Dollar weakens to new lows (on weak US economic data)
The lowest point in the smile reflects a weaker US dollar. Sluggish economic growth could trigger interest rate cuts, further weakening the currency.
Stage 3: US Dollar strengthens due to economic growth
The smile ends and signs of economic recovery appear. Investors are buying the dollar again, which leads to an increase in its value.
Index strength in historical perspective
The US dollar futures contract is actively traded on the ICE futures exchange, so we can easily use the historical chart of the dollar index to analyze the direction of the index value. I took this chart from TradingView:
In the chart above, I have made notes that show when key fundamental events occurred such as the Asian financial crisis, the Russian financial crisis, the US debt default, the burst of the dot-com stock market bubble, the US housing bubble, the financial crisis in the US in 2008 and the market shock from the Brexit referendum vote in the UK.
How to analyze the dollar index?
Traders can use movements in the index to get an idea of how the US dollar is moving against major currencies. For example, if USDX is rising, then it is likely that the US dollar will also rise. Conversely, if USDX falls, then the dollar is likely to fall as well.
Many financial media outlets report changes in the US Dollar Index to give their audiences an idea of how the US Dollar has performed in the forex market.
USDX can also be used as an inverse indicator of European Union currency strength, as the euro has an overwhelming 57.6 percent of the index. The next largest currency weighting in the index is the Japanese yen, at 13.6 percent.
The next key thing traders need to remember is how movements in the US Dollar Index compare to movements in quoted currencies against the dollar. For example, if a currency pair is quoted as USD/JPY, then USDX and that currency pair should be positively correlated, meaning it should rise at the same time and fall at the same time.
In contrast, when a currency pair is quoted as EUR/USD, that currency pair is inversely correlated. That is, it should move in the opposite direction when the dollar rises and, accordingly, fall when it rises.
How to use the dollar index in trading
There are many different strategies that traders can use when trading the dollar index. These will all vary depending on the type of trader and their trading style. The most widely used trading strategies include the use of trends, trend channels, price action and breakout trading. Let's look at some examples.
As the world's reserve currency, the dollar tends to create established trends. The trend trading strategy is one of many strategies popular among forex traders who are looking for signals to enter the market in accordance with the dominant trend.
The chart below clearly shows the trending periods. This is characterized by higher highs and lower lows, as well as longer periods of lower highs and lower lows.
The traditional approach to trend trading involves identifying a long-term trend and then looking for entry points using indicators, lower time frames, or price action patterns.
The chart below shows the downtrend after the dollar index reached its top. This downtrend forms by making lower highs and lower lows. Confirmation of a downtrend occurs when the market breaks a level and moves to an even lower low. At the moment, it is best to consider trades only in the direction of the trend.
Swing traders can use multiple time frame analysis when looking for their entry points. A longer period of time (daily time frame) allows the trader to establish an overall trend. Zooming in on the chart using a lower time frame (four-hour chart) will provide the trader with signals with a higher probability of entry when they occur in a trend.
Now that the downtrend is established, we can look for a sell entry point:
The chart below includes the stochastic indicator. Stochastic provides many entry points, so it is important to filter these signals to find trades with a higher probability.
As always, it is important to practice reasonable risk and money management before entering a trade to ensure that losing trades are not detrimental to your deposit.
