How the US Dollar Index can help your trading

Author: Giles Coghlan | Category: Education

The Dollar Index is another tool for your trading toolbox 

You don't have to be reading analysts posts or market wraps for very long before you come across references to the US Dollar Index. The US Dollar Index is a very useful tool in your trading as it can confirm a directional bias for the currency pair you are trading and also warn you of any headwinds that your trade might face before you pull the trigger. The Federal Reserve is the most important central bank in the world with the US dollar being the most traded currency in the world, comprising of around 70% of all transactions on a given day. So, having a handle on what the Dollar is doing overall on any given day is going to be a key advantage for any trader. The Dollar Index will help you do just that.

So, what is the US Dollar Index?

The US Dollar Index (USDX) started in March, 1973 for a value of 100.000. In February 1985 it traded as high as 164.7200 (depending on your price feed) and in March 16, 2008 it traded as low as 70.698.  At time of writing it sits around 95.32. You can see the approximate, historical  range of the Index below.
The Dollar Index is another tool for your trading toolbox 

The US dollar Index compares the USD to a basket of currencies

The US Dollar Index is a measure of the value of the US dollar in relation to the value of a basket comprised of some of the US's most important trading partners. The Index is comprised of six foreign currencies. Due to the fact that all these countries are not the same size ,the Euro  for example comprises of 23 countries, the USD Index gives varying weight to each currency. The biggest proportion of the Dollar Index (USDX) is made up of the EURO which has a 57.6% weight. The currencies are weighted in the following ways:

  1. The Euro (EUR), 57.6% weight
  2. The Japanese Yen (JPY), 13.6% weight
  3. The Great British Pound (GBP), 11.9% weight
  4. The Canadian Dollar (CAD), 9.1% weight
  5. The Swedish Krona (SEK), 4.2% weight
  6. The Swiss Franc (CHF) 3.6% weight

It will become immediately apparent that the Index is heavily influenced by the Euro. This gives us the first clue as to how the USD Index can be useful for making trading decisions.

The USDX is the Anti-Euro Index

When the Euro loses values this mean the Dollar Index gains value. The nearly 60% average weighting means that the EUR/USD pair and the USDX are inversely correlated. 

In the chart below, since May 2018,  the EUR/USD has been steadily falling
the EUR/USD has been steadily falling

In contrast below, since May 2018, the US dollar Index has been rising.

the US dollar Index has been rising

Armed with this knowledge the US dollar Index becomes an excellent indicator for the EUR/USD. At the time of writing the Index is testing the daily 200 moving average while the EURUSD is testing the daily 200 moving average. The Dollar Index can be eyed for clues as to the EUR/USD's next move

The US Dollar Index is a guide for the direction of the USD in any pair

Trading any pair with a USD half will be guided by the USD index, so here are a couple of key facts to keep in your mind:

•If the USD is the base currency (USD/xxx ), then the US dollar Index and the currency pair will typically move in the same direction.

•If the USD is the quote currency. (xxx/USD) then the US dollar index and the currency pair will typically move in opposite directions.

The US dollar index and the smile theory.

The US dollar index can give you a quick broad picture of the dollar and help you see what is going on with the market. The smile theory is worth mentioning since it is such a good way of mentally holding the three varying ways the dollar responds to different situations. If you look at the picture below you can see a kind of smile. 
Dollar smile theory
On the left hand side of the smile you have USD strength , which is when the global economy is struggling. This is where you have JPY, CHF strength and USD gains too as money is put into less risky dollars, The bottom part of the smile is where the USD depreciates on a dovish Fed. At the time of writing, in January 2019, the USD is falling with a more reserved Jerome Powell looking to the data before continuing the pace of hike rates. The right part of the smile is when the USD gains value on a hawkish fed and risk on environment. This smile theory is useful as a quick rule of thumb for understanding the dollars present position and what is likely to happen next. By getting into the habit of noticing the USD index as soon as you start trading you can speed up your analysis on the dollar and also gain invaluable insights to inform your next trading decision.
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