Unbiased Forex Broker Experts

Part I. Let’s Meet with Dollar Index

Let’s Meet with Dollar Index - Forex School
Commander in Pips: Well, we’ve taken a solid jump forward in terms of different analysis tools, so probably we will take a rest and switch to an easier context for awhile. I offer you to speak about the US dollar index.

Pipruit: Index? And what is this index?​

What is the US dollar index? - Forex School
Commander in Pips: Do you know something about stock indexes – S&P500, DJIA?

Pipruit: Yes. I’ve heard that they include average cost of all equities that they contain at some principle of averaging. So, it’s some kind of average value of stock market, some kind of barometer.
Commander in Pips: Right, precisely speaking, the value of particular equities in the index is not equal to each other – it based on the value of the particular company (capitalization). Larger companies have larger value in the index, while smaller companies - smaller values.

So, the dollar index is an analogue of a stock index but for the Forex market. It reflects the weighted average cost of the US Dollar compared to some other currencies. The collection of these currencies is called a “Currencies Basket”. This basket includes Euro (EUR), Japan Yen (JPY), British Pound (GBP), Canadian Dollar (CAD), Swiss Franc (CHF) and Sweden Crone (SEK). Weights of each currency are also different:

The dollar index is an analogue of a stock index but for forex market - Forex School
Source: Federal Reserve, Intercontinental exchange (ICE)

Pipruit:
 And why does the EUR have the largest value?​

Commander in Pips: As you understand, the EU includes 16 countries that have adopted the EUR. Since it unites a lot of countries, the EUR has such a significant value in the index. Japan also has one of the largest of the world’s economies – its value in the index is also significant. The second reason, I suppose, is that EUR is considered by some to be the second world reserve currency.

Pipruit: And where are the others? I mean Australia, New Zealand, other countries…Why just 6 currencies?​

Commander in Pips: Although you’ve said correctly and even 21 countries are just small part of the world, these countries are among the most powerful and affluent in the Global economy. Just remember the worlds reserved currencies. It means that many other currencies are followed by one of these countries, and adding some other currencies will give a shallow effect on overall picture.

Pipruit: And what we can do with this index?​

Commander in Pips: You may trade it - although not on spot forex but on the futures market. Intercontinental exchange (ICE) has a futures contract on dollar index (USDX) - $1000x Index value. In other words, if the index will change with 1 point your assets will change at 1000$. But this change is quite significant. Tick size (minimum fluctuation value) is 0.005 or 5$. Also you may trade options on dollar index – this could give you a lot of additional strategies and flexible opportunities.

Pipruit: Sir, I dare to suggest, that since USDX has significant correlation with EUR, it probably moves in the same direction as EUR/USD, so why do we need it at all?​

Commander in Pips: Despite the fact that the US dollar index indeed highly correlated (moves in mirror direction – see chart #2) with the EUR/USD, it could be very useful for long-term analysis, especially fundamental one. The point is that index was initiated in 1973 when floating rates where adopted by the world’s financial community. Such long-term history is very useful in long-term fundamental analysis, especially if you’re focused on economic cycles. Also it could be used for search of inter-market divergences. But in general you’re right – this index is highly correlated with EUR, but not only with EUR:

Correlation of daily returns since Jan. 1999 introduction of EURO - Forex School
Source: Bloomberg, Intercontinental exchange (ICE)
Pipruit: And what is inter-market divergence?
Commander in Pips: Well, we will talk about it later in detail… Since EUR/USD has 94% correlation with USDX, we may search divergence EUR/USD with US DX. If, say, EUR/USD has shown new high, while US DX does not show new low (since the correlation is negative) – this could warn us about a possible reversal. In other words, we deal with this as with common divergence, but use a US DX chart instead of some indicator. That is a very common practice.

Pipruit: Cool!
Dollar Index Interpretation

Commander in Pips: Here is the daily chart of US Dollar Index, the current quote is 75.972 points.

Chart #1 | Daily USDX
Daily chart of US Dollar Index - Forex School
Since this is an Index, it quotes in points (as in the Lord of the Rings movies – beer comes in pints). That’s quite common for any index quoting. For example, S&P 500 index also comes in points. The major difference between indexes is in value of the point. While S&P point value is $250, USDX point value is $1000. It means that if USD index will change from 77.000 to, say 76.000 and you have 1 contract short position with it – your assets will increase by $1000.

Dollar Index Interpretation continued

Commander in Pips: Since the index shows relative value of the USD to the average value of other currencies - reducing of the USDX tells us that the US Dollar value decreases (USD becomes weaker) compared to the average value of all the other currencies, while increasing if USDX tells us that the dollar is becoming stronger than all the other currencies on average.

Pipruit: Ok, and what it is tell us that US DX below 100 or above 100?​

Commander in Pips: Currently it’s not so significant. It just shows how strong or weak US Dollar to the day of index initiation in 1973. Here is what ICE FAQ tells us:

“The U.S. Dollar Index (U.S.DX®) is a geometrically-averaged calculation of six currencies weighted against the U.S. dollar. The U.S. Dollar Index was created by the U.S. Federal Reserve in 1973. Following the ending of the 1944 Bretton Woods agreement, which had established a system of fixed exchange rates, the U.S. Federal Reserve Bank began the calculation of the U.S. Dollar Index to provide an external bilateral trade-weighted average of the U.S. dollar as it freely floated against global currencies.”

So, standing of US DX below 100 tells, that currently US Dollar is weaker than the other currencies on average compared to 1973. Dollar Index futures is quite useful tool, since it trades at 24/5 basis, and has solid liquidity.

And the last thing here… Since different countries have different economy value – their currencies are also have different level of determination in overall USDX formula. Here it is:

Different levels of determination in overall USDX formula - Forex School
Source: ICE Futures US.

Also I have to warn you that since this is an index and domination of different currencies could change when time passes – the values could be re-adjusted. Still, there is no fixed and predefined schedule for this procedure.

Using the USDX in Trading 

There are two major ways of using the USDX in trading. The first one is just to trade them. If you are not sure about the relative strength of the US dollar to a particular currency, say GBP, but in general you see that the US economy is far from to be glossy and shining – you may sell USDX. If you will become right, then the US Dollar Index will decline, even if the GBP/USD will rise. So, this is some kind of diversification, like if you are sure that the stock market will rise but do not know what particular stock to purchase – you may purchase an index. Even if some shares will decline – overall the index will rise.

Second way is pictured on the chart #2.

Chart #2 | Weekly USDX (Black) vs EUR/USD (Maroon)
Using the USDX in Trading - Forex School
Here we see really strong negative correlation (almost 100%) of USDX with EUR/USD, but if you will be careful here – you’ll that from time to time some divergence appears between them. This is very common in major trend reversal points. That was right before the crisis in 2008 – EUR/USD has shown new top, while USD Index has not shown new bottom. The same was in 2009 and a small divergence in the beginning of 2011. This is weekly chart, but the same patterns you may find on lower time frames also.

Probably some hidden divergences also could appear here.

Pipruit: Other words, we can use USDX, as some kind of oscillator/indicator for EUR/USD to search for divergences?

Commander in Pips: Yes, we can, but not only for the EUR/USD. Take a look at CHF/USD also:

Chart #3 | Weekly USDX (Black) vs. CHF/USD (Maroon)
Weekly USDX (Black) vs. CHF/USD (Maroon) - Forex School
The same divergences you can find here. By the way – pay attention to yellow rectangle. We see huge growth of CHF/USD that was not supported by USD weakness. This has happened right before SNB intervention. Although this is very hard to use in practice – divergence was really huge, but this could help you to not buy CHF, since something is wrong here.

Pipruit: Really useful. In other words, the USDX is a barometer of US Dollar strength. So, if I see that the Index is growing, it means that the USD becomes stronger, and very probably other currencies in pair with the USD will become weaker or are becoming weaker. Significant move on the Index should be accompanied by similar moves on USD pairs. Also I can use it to search for possible divergences.
Commander in Pips: Yes. Let me make just a small additional clarification. Since USDX shows US Dollar strength – it has the opposite direction with XXX/USD pairs and the same direction with USD/XXX pairs.

Comments

One-fm
10 months ago,
Registered user
Great lesson.

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