In-depth Analysis

What is the Dollar Index and How to Trade It

What is the Dollar Index?

The U.S Dollar Index (USDX) is a collection of currencies that are often thought of as a representation of some of the most significant U.S trading partners across the globe. The purpose of the index is to track the value of the USD relative to those currencies.

It was formed in 1973, not long after President Nixon decided to dismantle the Bretton Woods System, which was an agreement and set of rules that governed the commercial and financial relationships between the U.S, Australia, much of Western Europe, Canada, and Japan from 1944.

The index was introduced at the time by the U.S Federal Reserve (Fed) and is currently maintained and coordinated by the Intercontinental Exchange, Inc. (ICE).

At its inception, the index included the German mark, French Franc, Italian lira, British Pound, Belgian franc, Swiss franc, Dutch guilder, Japanese yen, Canadian dollar, and Swedish krona. In 1999, when the Euro first came into use, it consequently replaced some of the other currencies, which has been the one and only adjustment that has come about for the USDX, reducing the number of included members to just six against the USD.

The USDX is measured in points and has had a base of 100 since it was established. Through the years it has fluctuated depending on what was going on around the world.

Understanding the numbers is quite simple – if the value of the index rises above 100, this means the USD is growing stronger relative to the other six currencies. If the index drops below 100, then the USD is weakening against them. The highest recorded value was back in 1984 when the index rose to nearly 165. At its lowest point, the index almost hit 70 back in 2007, when the financial crisis was starting to heat up.

What factors impact the Dollar Index?

There are numerous factors that can affect the index, such as: inflation, deflation, economic reports, major events, market sentiment, supply & demand, and a whole host of other generally macroeconomic conditions that can come into play. Anything that affects the individual currencies in the index and/or the USD itself can have an impact on the USDX.

Monetary policy is a major influencer on the movements of individual currencies, and thus the index as a whole.

When inflation is very high, central banks will generally lift interest rates to slow spending and bring inflation back under control, in line with their mandates at the time. When those interest rates begin to rise, the currency becomes more in demand as offshore investors who seek to purchase assets to take advantage of better returns must do so by swapping their own currency for the one in question. More demand increases value. The opposite can be true when inflation is low or national events cause the interest rates to drop.

When traders are attempting to interpret the ever-evolving value of the USDX, it’s important to also take into account the weightings allocated to the 6 other currencies. Price movements on the Euro, for example, will have a far greater significance than those of the Swiss franc. This is because the index is set up as a weighted geometric mean, and the Euro makes up more than half of the equation, as opposed to the Swiss franc, which accounts for under 4%.

The various weightings allocated to each currency are as follows:

  • Euro (EUR) = 57.6%
  • Japanese yen (JPY) = 13.6%
  • Pound Sterling (GBP) = 11.9%
  • Canadian dollar (CAD) = 9.1%
  • Swedish krona (SEK) = 4.2%
  • Swiss franc (CHF) = 3.6%

It’s also of note to be aware of the limitations of the index, given that it doesn’t include a couple of the US’s top trading partners – namely Mexico and China. For this reason, many traders use it as one of a number of vehicles to speculate on the value of the USD, rather than relying on it exclusively.

How to trade the Dollar Index

There are numerous techniques for investors to use in trading the USDX – one popular approach is to use derivative products, such as contracts for difference (CFD), futures, and spread bets. The index is also a part of the makeup of some ETFs and mutual funds.

With something like CFD, for example, with the support of a regulated broker like ActivTrades, you’re able to take advantage of margin trading to trade a larger amount of money to capitalize on movements in prices that are heading up (long positions), in addition to movements in price that are heading downwards (short positions).

Some traders choose to make use of the index as a strategy to hedge against downsides in their other investments with the USD. Others look at it as providing clarity in regards to forecasting the behaviors of the USD along with the different pairs in the Forex market by using technical and fundamental analysis.

Traders can monitor trends and apply leading or lagging indicators, and the use of chart patterns and candlesticks can be helpful analysis tools. Corrections or reversals might also be picked up ahead of time with inflection points like retracement levels and round numbers.

Whatever products you like to employ or strategies you have in place, it’s vitally important to make sure you have a trading plan in place ahead of time and that you actually commit to it. Managing your capital wisely in a manner that ensures you never risk more than you’re prepared to lose and using money and risk management rules should ensure your investing career for the long term.

 

 

The information provided does not constitute investment research. The material has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and as such is to be considered to be a marketing communication.

All information has been prepared by ActivTrades (“AT”). The information does not contain a record of AT’s prices, or an offer of or solicitation for a transaction in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information.

Any material provided does not have regard to the specific investment objective and financial situation of any person who may receive it. Past performance is not a reliable indicator of future performance. AT provides an execution-only service. Consequently, any person acting on the information provided does so at their own risk.