FX Basics: Trading the US Dollar Index

10/14/2011 6:00 am EST

Focus: FOREX

This resource describes how the US dollar index is comprised, how traders in a variety of markets analyze it, and the primary ETF choices for those looking to trade fluctuations in the index.

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 other 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 (EUR), Japanese yen (JPY), British pound (GBP), Canadian dollar (CAD), Swedish krona (SEK), and Swiss franc (CHF). Each of these currencies are given a weight within the index with the largest weight given to the euro.

It is a weighted geometric mean of the dollar’s value compared only with:

  • Euro (EUR), 58.6% weight
  • Japanese Yen (JPY) 12.6% weight
  • British pound (GBP), 11.9% weight
  • Canadian dollar (CAD), 9.1% weight
  • Swedish krona (SEK), 4.2% weight
  • Swiss franc (CHF) 3.6% weight

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.

See related: Navigate Upcoming EUR/USD Volatility

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.

See related: Why the Dollar Index Needs an Overhaul

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.

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 the US Dollar Index Bullish Fund (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 the US Dollar Index Bearish Fund (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.

By the Staff at TheLFB-Forex.com

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