The application of the US dollar index in foreign exchange trading

If you trade stocks, these stock indices such as the Dow Jones Industries Average Index (US30), the Nasdaq Composite Index (NAS100), the S & P 500 Index (S & P500), and others should be familiar to you.

Since the US stock market has a stock index, the US dollar will also have its own index.

For foreign exchange traders, the US Dollar Index (USDX) is an important indicator that cannot be ignored.

The dollar index is used to measure the degree of change in the exchange rate of the dollar against a basket of currencies. It measures the strength of the dollar by calculating the combined rate of change of the dollar and the selected basket of currencies, thereby indirectly reflecting changes in the competitiveness of US exports and import costs.

The dollar index includes six currencies, which are:

1. Euro (EUR)

2. Japanese Yen (JPY)

3. Pound Sterling (GBP)

4. Canadian Dollar (CAD)

5. Swedish Krona (SEK)

6. Swiss Franc (CHF)

So now that we know which currencies the dollar index is composed of, let's take a look at how the dollar index is calculated.

The calculation principle of USDX futures is to calculate the overall strength of the dollar in a weighted manner based on the trade settlement volume between major countries in the world and the United States, and to divide the strength by 100 points.

Each country is different in size, so to be fair, they are also weighted differently in the dollar index.

The chart below shows the weight of each currency in the US dollar index

We can see that the euro is the most important and weighted currency in the US dollar index, with a weight of 57.6%. Therefore, the fluctuation of the euro has the greatest impact on the strength of the USDX

The second largest weighting is the yen, as Japan is also one of the largest economies in the world.
The combined weight of the other four currencies does not exceed 30% of the dollar index.

Like other currency pairs, the dollar index also has its own chart (see chart below).

The dollar index is calculated 24 hours a day, 5 days a week

In addition, the dollar index is based on the baseline of 100.00 in 1973 when the dollar index was first launched to distinguish the strength of the dollar. For example: the dollar index is now 104.4, which means that the dollar has risen 4.4% since the index was launched.

So, how should we use the US dollar index for foreign exchange transactions?

The most liquid currency pairs in the world basically include the US dollar, such as the euro against the US dollar, the British pound against the US dollar, the US dollar against the Japanese yen, the Australian dollar against the US dollar, and so on.

Commodities such as gold, crude oil, and natural gas in the international market are mostly priced in US dollars, so commodity prices are negatively correlated with the US dollar index.

existforeign exchange marketThe dollar index is regarded as a bellwether for the strength of the dollar.

We previously mentioned that the weight of the euro in the US dollar index is as high as 57.6%, so there is a negative correlation between the euro and the US dollar index.

Dollar index sky chart

EUR/USD chart

Have you noticed that the dollar index and the euro are like a mirror against the dollar?

When one goes down, another one is likely to go up.

We can see that the trend lines of the two charts are almost perfectly negative, which is a great help for traders trading the EUR/USD pair.

Therefore, when trading currency pairs related to the US dollar, we must always observe the performance of the US dollar index.

Every time the dollar index rises, there is a high probability that non-U.S. currencies will decline accordingly

Every time the dollar index falls, there is a high probability that non-U.S. currencies will rise accordingly

Summarize:

If the US dollar is the base currency (USD/XXX), then the US dollar index and the pair should move in the same direction.

If the US dollar is the quoted currency (XXX/USD), then the US dollar index and the pair should move in the opposite direction.