Will the dollar index continue to rise?
What is the US Dollar Index and how do you trade it?
The US Dollar Index is a useful tool for day traders and swing traders. In this article, I'll show you what exactly is behind the USD index and how you use it.
With a daily trading volume of around USD 5 trillion, the USD is still by far the most traded currency in the world. Its value is of great importance to many economies.
In today's post I would like to introduce you to the US Dollar Index (USDX; ISIN: XD0009982303 or abbreviation "DXY").
Perhaps you have already come across the USD index while searching for the US dollar in the Forex area, but you may not have been able to do too much with it.
The US Dollar Index was introduced in 1973 with a starting value of 100. It has been listed on the US futures exchange ICE Futures since then and can be traded directly there as a future.
Alternatively, you can trade the index through ETFs, CFDs and options.
What exactly the USD index is and how it is composed, you will now find out below.
What is the USD Index and how is it made up?
The US dollar index is a key figure that compares the value of the US dollar with the help of a currency basket.
So it is not, as you may already know, an exchange rate between two currencies (e.g. USD / EUR), but a comparison of several international currencies.
With time and changes in Europe, this basket has also changed over the years.
This basket of currencies has contained a total of six currencies since 1999:
- Euro (EUR)
- Japanese yen (JPY)
- British pound (GBP)
- Canadian dollar (CAD)
- Swedish krona (SEK)
- Swiss Francs (CHF)
Before 1999, the basket contained the original currencies of the largest euro countries for the euro. This gave the basket a greater choice with ten currencies until the introduction of the euro. For the euro, the German mark, the French franc, the Italian lira, the Dutch guilder and the Belgian franc were included.
How is the "USD Index Basket" composed exactly?
It is important that not every currency is weighted at 16.6% against the US dollar.
In the composition, the trade volume of the USA with the nation of the respective currency is looked at and weighted accordingly. This counts for the trading volume of the euro all Participants in this common currency.
The current US dollar index is weighted as follows:
- Euro 57.6%
- Japanese yen 13.6%
- British pound 11.9%
- Canadian dollar 9.1%
- Swedish krona 4.2%
- Swiss franc 3.6%
Adjustments can be made here at any time, should one country lose importance in the world economy and another gain in importance.
The lowest weighted currencies are most likely to be named here as possible exit candidates. In this case Sweden and Switzerland.
China, South Africa or Mexico can be named as possible “candidates for promotion”.
Meaning of the weights:
According to the current ratio, one US dollar is offset by 0.576 euros, 0.136 Japanese yen, 0.119 British pounds, etc.
The index value is then calculated using the following formula:
The product of all currencies in the basket is calculated after taking the respective weighting as an exponent.
Finally, the result is multiplied by 50.14348112.
Written out it looks like this:
Value of the US dollar index
= ((EUR ^ 0.576) * (JPY ^ 0.136) * (GBP ^ 0.119) * (CAD ^ 0.091) * (SEK ^ 0.042) * (CHF ^ 0.036)) * 50.14348112
Fortunately, of course, you don't have to perform these calculations every time, you can call up the index status on the Internet. Nevertheless, I think it is useful and important to know the underlying calculations. It is always important to know how something that you want to observe and use for yourself is composed and not just used, as it is recommended by many and considered useful.
Use the USD index in trading? That's how it's done:
How can you now use the daily US dollar index for your trading?
To do this, you first have to know how to correctly interpret the index and which course allows which statement.
Here is the US dollar index chart over the last 12 months:
Below you will find the development of the USD index since the beginning.
US dollar index since the start of the calculation in 1973
In general, it can be said that when the US dollar index rises, the strength of the US dollar increases compared to the currencies in the basket.
The other case is of course the other way round. If the US dollar index falls, the US dollar loses strength against these currencies.
If the US dollar index is currently at a value of 120 and the initial value was 110, it can be concluded that the US dollar has appreciated by 9.09% against the currency basket over the period under review.
So it is possible to get an objective picture of the US dollar and not just look at a currency pair (e.g. EUR / USD) and try to infer a strength or weakness of the dollar from this exchange rate.
Many experienced forex traders use this index before making any trade in any USD currency pair.
These traders want to check whether the current strength / weakness in the currency pair is a general trend of the USD, or whether the current strength / weakness in this currency pair is actually an exception.
This is to avoid trading against the general trend of the USD in the market and perhaps missing important data or news about the “outbreak” currency pair.
The USD is trading weaker across all currency pairs throughout the day. Now comes an unexpected message from Great Britain in which it is said that something is not going according to plan with the subject of Brexit. The British pound then depreciated against all currencies. Also against the US dollar, which was actually weak that day.
As a trader, I may only see at this moment that the US dollar is rising against the British pound and am thinking about an entry short in the GBP / USD.
The idea of betting on a further falling pound is correct. But is the US dollar really the right choice just because it is currently rising against the pound?
With a quick look at the US dollar index, I can now immediately ascertain whether the US dollar is a good choice as a strong currency.
I immediately see that the US dollar index is trading lower than before on this day and that the supposed strength against the British pound is only due to the fact that it is even weaker. So here the strength of another is only simulated by an even weaker currency.
So I could avoid trading two weak currencies against each other.
I can look for a strong currency before the trade so that I can increase my chances and implement this good trading idea in an "optimized" manner.
If you are interested in trading strategies in forex trading, be sure to check out Tim's free Trader Webinar. Here you can sign up
Of course, in this example, I could possibly also make profits with the USD. Taking a really strong currency that day should be better for my performance in the long run.
I hope I was able to introduce you to the US Dollar Index, a rather old but very useful index for your Forex trading.
If you didn't know this index before, try it out as a little "hedge" before your next USD trade and maybe this will help you in the future not to rush to trade the USD against its actual trend.
Do you still have questions about this index, have you already had experience with it or just general questions about trading? Then just use the comment function under the post and tell us about it!
I wish you a nice week of trading
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