The US Dollar is the most traded currency in the world. It is used as a currency of the majority of international transactions while also being part of the most popular currency pairs on the Forex market. It is no wonder that the US dollar has its own index which evaluates its value against other global currencies. In this article you’ll find out what the US Dollar Index is, how it is calculated, and whether there are ways to use this index in your trading strategy.
What is the US Dollar Index (DXY)?
The US Dollar Index (commonly written as USDX or DXY) is an indicator that measures the value of the US dollar against a basket of six foreign currencies. These currencies include the euro, the Japanese yen, the Great Britain pound, the Canadian dollar, the Swedish krona, and the Swiss franc. The DXY works similarly to stock market indices as it evaluates the strength of the USD on global markets.
The reason this index is important to traders is because the USD is considered a global trading currency and the world’s primary reserve currency. The vast majority of trades across all financial markets is done with the US dollar. Knowing its current value against other currencies can help you plan for more profitable trades.
History of the US Dollar Index
The US Dollar Index was first introduced in 1973 after the Bretton Woods system was abandoned. This system established the US dollar as the international reserve currency, fixing the value of the other currencies to the dollar, which in turn was tied to the value of gold (one ounce = $35). However, the system caused the US gold reserve to deplete, and the USD couldn’t hold to its value. Because of this, the DXY was established as a way to record the value of the currency.
At first, the base value of the USD was set at 100.000. However, it has fluctuated throughout the decades, rising to its historical maximum (164.720) in 1985 and hitting the historical minimum (70.698) in 2008.
Throughout the years, the basket of currencies against which the USD is measured has been altered only once in 1999, when euro was added to the list. Currently, a lot of experts argue that it is time to revise the basket and include other currencies (such as the Chinese yuan and the Mexican peso) to reflect the countries the US is currently actively trading with.
How to use the US Dollar Index in trading?
There are multiple ways to use the DXY in trading. Here are some of them.
Trend indicator
The DXY can provide a lot of useful information to Forex traders who trade the USD against other currencies. One of the ways you can use it in your Forex trading is by identifying the current USD tendency. Knowing whether the USD is experiencing an uptrend or a downtrend in value can help you plan your Forex trades accordingly. If the DXY indicates an uptrend in value, it is best to buy the USD against other currencies. If the USD is going through a downtrend, it is time to sell the USD against another, stronger currency.
Trading correlated currency pairs
Another way to apply the DXY in trading is to use it as a source for additional trading signals. The US Dollar Index has quite a lot of influence on the currency markets as many traders use its support and resistance levels and price patterns to plan their Forex trades. Correlated currency pairs are the pairs that move in the same direction as the DXY (USDJPY, USDCAD, USDGBP, etc.). In order to trade them, you need to find a confirmed technical analysis pattern on the DXY chart and look for a correlated currency pair that has the same picture on its price chart. Once you do, open a position for the correlated currency pair in the direction of the DXY trend.
For example, on August 16, 2022, at 12:00 MT, the US dollar index broke out from the bullish flag.
At the same time, USDCHF didn’t have any valid patterns. However, if traders had entered a buy trade in USDCHF at the same time as the US dollar index flag’s breakout happened, they would have caught a solid pump.
Trading currency pairs with an inverse correlation
Unlike correlated ones, currency pairs with an inverse correlation move in the direction opposite to the DXY. This includes EURUSD, AUDUSD, NZDUSD and other pairs. To make use of the DXY, find a confirmed technical analysis pattern on its chart, and then look for a similar pattern on the chart of one of the currency pairs. Once you find it, you should open a position for this pair in the direction opposite of the trend on the DXY chart.
You can learn more about the US Dollar Index technical analysis from the FBS Trade Analytics team.
What is the US Dollar Index futures contract?
The US Dollar Index futures contract is a form of the DXY that can be traded on the financial markets. To trade a DXY futures contract, you need to open a futures trading account. After you’ve done this, you can trade a DXY as an ordinary asset, buying and selling it to make profit from its price fluctuations. You can also use it to hedge against losses from trading USD on the Forex market.
With FBS, you can’t trade the US Dollar Index. However, if you open MetaTrader 4 or MetaTrader 5, click view, enable Market Watch, scroll down to the list of the assets, and type “USdollarindex” into the search field, you will be able to open the index chart. Analyzing this index can help you to predict the movement of most of the major currency pairs, metals, and even the US stock market.
What affects the price of the US Dollar Index?
The price of the DXY can be affected by changes in the prices of the US dollar and any currencies included in the DXY currency basket. The events that might lead to these changes include economic recession or growth, inflation or deflation, geopolitical conflicts, export and import, etc. The price of the US Dollar Index also rises when the demand for the USD is high, and falls when the demand gets low.
How to calculate the DXY price?
The US Dollar Index is calculated by taking the average USD exchange rate against six foreign currencies and normalizing it by an indexing factor, which is about 50.1435. Each currency has different weight percentages that are also included in the calculation:
- Euro – 57.6%
- Japanese yen – 13.6%
- Great Britain pound – 11.9%
- Canadian dollar – 9.1%
- Swedish krona – 4.2%
- Swiss franc – 3.6%
The full formula used to calculate the DXY looks like this: DXY = 50.14348112 × EURUSD^-0.576 × USDJPY^0.136 × GBPUSD^-0.119 × USDCAD^0.091 × USDSEK^0.042 × USDCHF^0.036
The Dollar Smile Theory as a trading strategy
The Dollar Smile Theory was first introduced about 20 years ago by economists Stephen Jen and Morgan Stanley. They noticed a strange correlation between the state of the global economy and the strength of the USD. They concluded that the USD constantly cycles through three stages:
- Stage 1. The USD is strong while the global economy is in shambles. This happens because the USD is seen as a ‘safe haven’, and during times of economic hardship investors prefer to move their money into safe assets, which increases the value of the USD.
- Stage 2. The USD becomes weak when the global economy recovers from a recession. While the US economy is still getting back on track, investors move their money again, choosing outperforming currencies as their next resort.
- Stage 3. Once the US economy also rebounds, investors start enjoying the GDP growth and expect higher interest rates in the future, making the USD an attractive asset again.
This illustration shows the stages of the cycle. You can see why this theory is called “the Dollar Smile”. Knowing this tendency, you can use this peculiar nature of the USD to your advantage and utilize the US Dollar Index to plan your long-term trades.
Conclusion
The US Dollar Index is a very important indicator that allows traders to see the changes to the value of the USD in real time. This index can help you predict price movements of major currency pairs on the Forex market and find opportunities to enter Forex trades.
