How to Trade the USD Against a Basket of Currencies

11/17/2009 12:01 am EST

Focus: FOREX

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

The US dollar index (USDX) is an important analytical tool for traders in just about any market. The USDX is actually a futures contract, which means that if you have a futures trading account, you could trade this instrument like corn, oil, gold, or currency futures contracts. However, rather than trading the USDX, most retail traders use it as way to analyze the relative strength or weakness of the US dollar in general.

The USDX compares the US dollar (USD) against a basket of other world currencies. This basket represents most of the largest free-floating, major currencies in the world on a weighted average basis. The currencies included are the euro, yen, British pound, Canadian dollar, Swedish krona, and Swiss franc. Each of these currencies are given a weight within the index, with the largest weight given to the euro.

Because the euro is typically half the total weight included in the average, the chart for the USDX will often look like a chart of the USD/EUR futures contract. Spot forex traders will notice that the USDX is very similar to an inverse of the EUR/USD spot forex pair. However, because the USDX includes six different currencies, it is a better measure of USD strength than any single currency pair including the EUR/USD.

The USDX was established in 1973 with a starting value of 100. That means that if the USDX is measuring less than 100, the USD has lost relative value compared to what it was worth in 1973, and if it is above 100, then the USD is stronger than it was in 1973. Currently, the USDX is hovering around 82, which means that it is 18% weaker than its starting value. The dollar has not always been weaker than it was in 1973. As you can see in the monthly chart below, the USDX showed a 20% improvement in value in the USD in 2001 and 2002. 


Click to Enlarge

The USDX is particularly useful for traders in the bond, currency, and gold markets. For example, a strong USD is usually correlated with falling gold prices, which means that gold traders are very interested in a breakout on the USDX, even though they may not be trading the USD directly. Similarly, global crises often increase demand for the USD as investors seek a shelter from uncertainty. This will drive the value of the USD up, and often, bond yields will drop. These are just two examples of how the USDX is one more intermarket tool you can use for evaluating capital flows and finding new trading opportunities.

You can find charts for the USDX on the pairs analysis pages in the forex section of the Learning Markets Web site, but if you are interested in trading the USDX, you have two attractive alternatives.

First, you can open a futures account. There are futures and options on futures available on the USDX that trade on the New York Board of Trade.

Second, you can trade ETFs that track the USDX itself. PowerShares offers two ETF alternatives for trading the index. The first is UUP, which invests in long futures contracts on the USDX, which means it will move the same direction as the dollar index. The second is UDN, which invests in short futures contracts on the USDX, which means that it will rise in value when the dollar index weakens. If you are bullish the dollar, you could buy UUP, and if you are bearish the dollar, you could buy UDN. 

Watch the video now for more information:

By John Jagerson of LearningMarkets.com

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