US Dollar Index: Reversal Confirmed, Rally Has Begun!

Significant trend reversals usually take some time to complete, and in the case of the US dollar index (DX), there appears to be plenty of technical evidence confirming that the reversal is a done deal, with substantially higher prices due in the next few months. Here are a few key technicals that can help swing and position traders get a better handle on just how far the dollar’s newfound strength may actually take it.

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Plotted on this chart is a pair of Keltner channels, set as follows:

Inner bands: Set at 4.235 average true ranges (ATR) away from a 45-period exponential moving average (EMA).

Outer bands: 7.5 average true ranges (ATR) away from the same 45-period exponential moving average (EMA).

While these are not magic formulas for Keltner channels, this particular pair do a very respectable job of defining key support and resistance levels in any given stock or commodity, and in almost any time frame. You may find that using a 3.75 to 4.5 ATR setting for the inner bands to be especially useful, while settings of 6.5 to 8.0 can be more appropriate for the outer bands. Similarly, you can use a 40- to 50-period EMA for the key moving average that the ATR multiples are based upon.

On the chart above, the Keltners do a very nice job of defining meaningful support and resistance levels in the US dollar index futures contract. You really shouldn’t trade with Keltner channels alone, but they can give you extra confidence as you time your various trade entries/exits using your preferred trading strategy. Right now, the DX is surging higher after the pair of bear trap “wash and rinse” reversal bars printed (see blue ovals on chart) in late October and early November, respectively, signaling the intentions of this key currency contract to at least try and stage some sort of a meaningful relief rally.

Well, the rally soon materialized, causing the DX to rise all the way to 79.585 (easily taking out the Keltner mid-line in the process) by November 16, 2010. Then we witnessed the recent pullback that brought it back down for a re-test of the Keltner mid-line (the center line on the Keltner complex, which is the 45-period EMA referred to earlier). This is a typical price pattern that occurs in the emerging stages of a new trend (breakout; pullback to support; continuation of trend), and the case for a strong bull move now for the DX is also made by the failure of prices to even wait for a full retracement to the Fibonacci 38.2% support before surging higher.  Of key interest to DX traders is the fact that the Keltner mid-line is a terrific trend-delineating “line in the sand,” which simply means that once you see a breakout of the mid-line (in either direction), one followed by a successful support/resistance retest of the line, you can be reasonably sure that the trend in question is likely to keep moving in the direction of the breakout for a meaningful period of time.

The next key resistance for the DX is 79.585, the prior daily swing high; if that price is taken out on a daily close above 79.590, plan on the DX to quickly surge all the way to the next major resistance level (blue shaded area on chart), which coincides with the inner Keltner band near $81.77 and a prior resistance area formed in mid-September (September 14 thru September 21, 2010) on the daily chart.

With the gold and silver markets having already signaled that a substantial correction is underway (my target for gold support is $1,251, likely to be seen within the next three to five weeks as the DX works its way higher toward $82.00), this bullish trend reversal in the US dollar index provides additional confirmation that the metals complex is once again ready for its bi-annual shakeout (see daily and weekly gold and silver charts for 2004, 2006, and 2008 if you doubt this), a substantial corrective move that typically provides excellent places for silver and gold bulls to re-enter the precious metals market once the selling carnage abates. Don’t even think of putting on new long metals positions until you see if $1,251 holds as support in the gold market.

If you’re currently long a lot of gold and silver futures contracts, you should seriously be thinking about an exit strategy before this bullish move in the DX eats away at your gold/silver positions. Learn to set up similar Keltner charts on the metals contracts you follow and see if they won’t also help you stay on the right side of those markets, too.

By Don Pendergast of ChartW59.com