US Dollar Index Explained

I mentioned the other day about avoiding information overload in your trading.

But there is one piece of information that you don’t want to miss.

In fact, this one little chart could give get an excellent overview of what’s happening in the markets…

And more importantly: where they could be going.

It’s called the US Dollar Index (USDX).

Now, if you’re anything like me, you probably speculate on movements of currencies primarily against the US Dollar.

So in effect if you go short GBP or EUR, you’re taking a long position on the USD.

And you’ve probably noticed that what happens with the US Dollar in one currency pair often happens in the other currency pairs.

This is called correlation.

So, in the major currency pairs such as EUR/USD, GBP/USD, AUD/USD you tend to get long periods when the USD is clearly in favour or out of favour.

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The US Dollar Index can help you spot the overall trend

These periods of favour can sometimes last for six months or so.

So, if you could spot when the USD is in favour or out of favour, you could do very well in your trading.

This is where the US Dollar Index (USDX) could help you.

It’s a simple measure of the value of the USD against a basket of foreign currencies.

A basket is simply a combination of the other currencies.

If you want a more technical definition: the USDX is a geometric progression weighted average.

But basically all that means is that when it started in 1973 it was 100 and now its value moves up or down relative to this original level.

Now, the USDX basket includes six currencies…

You’ve got the British Pound, the Euro, the Japanese Yen, the Swiss Franc, the Canadian Dollar and the Swedish Krona.

And that’s why this one chart can really help your longer term trading.

Because from this one USDX chart you can instantly see the USD price movements relative to other currencies.

And it can give you a very good indicator of the longer term trend.

Let’s have a look…

Here is the US Dollar Index chart (from Bloomberg).

You can see from December 2009 until the beginning of June 2010 the USDX was going up from 74 to around 88.

The trend was clearly up.

This was when risk was hitting the markets again, with the Euro debt crisis in full flow. The USD was strengthening.

Then suddenly the index (USDX) dropped back from 88 to 80, from June to the beginning of August.

So in June and July risk seemed to be subsiding and the markets thought the US economy was improving.

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Now look at the most recent movements over the last month at the right hand side of the chart.

Since the first week of August the USDX has started to bounce back up, as risk is returning with a poorer economic outlook.

This is because the US Dollar is still thought of as a safe haven currency.

That means when everything goes pear shaped, everyone rushes for the doors and sells their foreign currencies.

And buys the US Dollar.

So, looking at this USDX chart it looks to me like the US Dollar strength may continue.

Especially if worse economic news comes out.

So I’m planning my longer term trades with this in mind.

You may want to check this simple chart from time to time in your trading too.

You can find the chart on the Bloomberg site here: US Dollar Index

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