Building a Better Dollar Index

03/08/2013 1:00 pm EST

Focus: CURRENCIES

Derek Schimming

Co-Founder and Lead Trader, TradingFX

The dollar index has been little changed since 1973, so it is outdated. Derek Schimming talks about a modified version that traders may find far more useful.

My guest today is Derek Schimming of TradingFX.com.  We are talking about the modified dollar index and something else he uses that we want to talk about in terms of currency trading.  So Derek, you have a different way of looking at the currency trading with these modified dollar indexes? 

Yeah, the dollar index was created in 1973 and in this time since 1973 nothing has ever changed for the dollar index other than adding the euro into it, so if you look at the weightings of a dollar index it is actually quite erroneous based on modern day currency flows.  So what we did is we took the statistical data from the Bank of International Settlements, looked at the three-, five-, and ten-year data and we have adjusted the weightings to accurately apply to modern day currency flows. 

We also made it a little bit more sensitive to how price moves in this day and age, so even though our dollar index is a slightly different numerical level it is still a dollar index, it just becomes more sensitive and more active based on how traders use it today.  It is a great overview tool and if you think about the correlation between the dollar and the yen, the dollar and the yen 90% of the time are moving the same direction; there is not too many pairs a trader would venture into that don't have either a dollar or a yen component, so looking at a dollar index, especially one that is very sensitive to price movements that is accurately weighted, becomes a fantastic overview tool. 

Now how do you use this in conjunction with the currency strength index?

Well, the currency strength index is taking that a little bit further.  What the currency strength index does if you take the average trader who will let's say I want to trade euro-dollars and I think euro-dollars are going up, so I'm assuming that the euro is strong and the dollar is weak.  Traders by nature will then go look at the euro-yen.  If the euro-yen is going up well the euro must be strong and I will go look at the pound-dollar; it's going up.  The dollar must be weak.

What we do is it is cross currency analysis.  Our currency strength index is basically doing that times 1,000 because we are looking at one of the largest liquidity pools in the world, showing the electronic trades from over 80 or 70 something brokers globally.  We are doing cross currency of all the executions that we can see done electronically, stripping out the individual currency activity and displaying each one on a simple line format.  So again, it is a nice overview tool; I'm looking at which currencies are moving up, which currencies are moving down, which currencies aren't really moving, some are more volatile than others, so I'm really looking at what is consistently moving up?  What is consistently moving down and what is not?

You might have your basket of currency pairs that you prefer to trade, but it might not be the day for them.  I may love euro-dollar, but the euro is flat and the dollar is just going down a little bit, and you look over and you see the pound is moving very strong and the yen is moving down very weak and all of a sudden it is what I call your short list, every trader should have a short list; a group of pairs they trade by looking at the currency strength index I can isolate and know what each individual currency is doing and then my short list becomes my focus list because I know where the best opportunities lie today and based on a hedge transaction in a spot currency market, I want one to be moving up and one to be moving down, so by looking at the currency strength index, then I'm putting myself in a position where both currencies arguably are moving in the direct of my trade.  It doesn't mean both of them are rapidly moving in my favor, but I'm trying to avoid one moving against me, number one. 

One currency is usually going to carry the load of the trade, in most cases, but again, it is putting myself where I have an advantageous situation of what is having the greatest divergence and convergence in the marketplace, so my short list becomes my focus list and that is how I spend my day. 

It sounds like this is also a great way to start the day to get a broad overview of how everything is going.  If you look at the checklist of what I teach people to do, it is the first thing we look at; you start your day by looking at, there are three versions of the CCYX; we look at the broader version first, consider just a snapshot overview of the market, and then we go into more detail, and then we move into the pairs.  It is absolutely the first thing you look at and then it becomes your peripheral vision at all times.  So that is how we start.  That is absolutely a great observation because you are right.

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