Dollar index in forex trading assists traders make profitable decisions.
Currency traders globally realize that the American Dollar (USD) is the most traded currency in the world. It forms one part of the most traded currency pairs and is the base currency of choice when trading exotic pairs.
Thus, it is ideal for any forex investor working for profits to ensure that they are up to date with USD price movements.
Nevertheless, watching the performance of the USD against one currency will not provide an accurate picture of market conditions. It is more prudent to compare the performance of the dollar against multiple other major currencies.
Dollar Index Definition and Examples
It would be tedious if you had to do a comparative analysis of the performance of the dollar against the Euro (EUR), then against the Canadian Dollar (CAD), and then repeat the process with the Australian Dollar (AUD), the Swiss Franc (CHF), and all other major currencies.
Thus, the Dollar index (DXY) was born though there is no agreement on how best to formulate this index. It is for this reason that there have been multiple dollar indices introduced to accurately gauge the value of the dollar and monitor its price movements.
a) The Standard US Dollar Index
The standard United States Dollar index (USDX) was formulated in 1973 by the Intercontinental Exchange (ICE) in 1973 to ease commodity exchange. This index measures the value of the USD against a basket of 6 major currencies.
This works much like how the FTSE 100 is used to gauge the strength or weakness of the London Stock market. The USDX is measured against the Euro, the Yen (JPY), the Swedish Krona (SEK), the Swiss Franc (CHF), the CAD, and the Sterling Pound (GBP).
Each of the currencies is assigned a weight that is derived from their share of trade with the US in the 1970’s. For that reason, the USDX is usually slightly skewed towards the EUR value.
The USDX has only faced one update in 1999 after European countries adopted a single currency thus the EUR has a weight of 57.6 on this index.
b) The Trade Weighted US Dollar Index
The Federal Reserve formulated its own dollar index which gets annual updates and is largely based on yearly trade balances. The Federal Reserve uses this to reflect changes in commercial activity while the ICE argues that trade are not the only driver of currency value.
c) Dow Jones CME Dollar Index
Many traders felt the USDX was outdated and the Trade weighted index was not reflective of all driving factors. For that reason, in June 2010 the Dow Jones and the Chicago Mercantile Exchange (CME) unveiled their own dollar index.
The Dow Jones CME FX$INDEX is favoured for use in futures contracts and while it also uses a basket of 6 currencies, the Krona is replaced by the Australian Dollar (AUD).
However, since 4 of the futures contracts out of a total of 11 are EUR-based, the index is skewed heavily towards the value of the EUR.
d) Equal Weighted Dollar Indices
With previous indices being heavily skewed toward an EUR which bears a much larger standard contract size compared to the USD, there has been demand for a more reflective index.
Thus, there have been several equal-weighted indices and one of the most used is the Dow Jones FXCM Dollar Index unveiled in 2011.
This is an index which pits the dollar against 4 equal-weighted most liquid currencies. These currencies are the EUR, GBP, AUD, and JPY.
This index is touted by its proponents as easier to formulate and use regardless of it being criticized as being over-simplistic.
Many argue that using only these 4 currencies leaves out lots of other important currencies that have a strong bearing on the true value of the USD.
In response to growing economic influence of the People’s Republic of China and its currency, the Renminbi (CNY or RMB), the Curex Group and FTSE launched their own dollar index in June 2012.
The FTSE Curex USD G8 Index gauges the USD against 8 equal-weighted currencies. These are the AUD, CAD, CHF, RMB, EUR, GBP, JPY, and the New Zealand Dollar (NZD). Nonetheless, this index has been criticized due to the fact that the RMB is not a free-floating currency.
In July 2012, The Wall Street Journal used the Bank of International Settlements reports on currency trading volumes to devise their own WSJ Dollar Index. This is based on the dollar’s performance against 7 key currencies.
Trading With the Dollar Index
Click here to access the dollar index from Fxstreet.
By comparing recent dollar trends, traders can determine how the most commonly used indices reflect the true performance of the USD against other major currencies.
This information can be used to predict future trends and profit handsomely through forex trades.
Bullish or Bearish
Comparing the dollar index in forex trading to a single currency may not give a proper indicator on the strength of the USD. The dollar might gain due to political turbulence in the other country or lose due to a fiscal policy change for the other currency in the pair.
Hence, the use of the dollar index gives a better presentation of the true performance of the USD. Knowing whether the USD is bullish or bearish provides traders with the right indicators on whether to buy or sell.
Price Breakouts
While indices often operate on small price deviations, they can still be used to identify imminent price breakouts. A keen trader can then use a straddle strategy and place buy or sell orders depending on the direction of the price breakout.
Trading the Index and CFDs
To reap from forex trade using the dollar index, traders may trade the index with Contracts for Difference (CFDs). The CFD on the index is based on a 24-hour quote and has a very small margin.
Conclusion
To successfully profit when using the dollar index in forex trading, keep in mind that the USDX is most active in the morning from 0800 to 1200 EST and reaches its peak at around 0930 EST when the general financial markets are opening.
Additionally, keep in mind that the dollar index behaves like most other world currencies and financial instruments and thus, it is affected by economic factors, labor statistics, and political news.
