The US Dollar Index and how you can trade it?
What is the US Dollar Index?
The US Dollar Index (DXY, DX, USDX) measures the value of the US dollar in relation to a basket of other currencies, including those of the US’s major trading partners. The Dollar Index rises when the US dollar strengthens against the basket’s other currencies and falls when the dollar weakens.
Currencies included in the US Dollar Index?
The US Dollar Index compares the US dollar to six other currencies: the euro, the Swiss franc, the Japanese yen, the Canadian dollar, the British pound, and the Swedish krona.
Since the index’s inception, the currency basket has only been changed once. The euro replaced many European currencies previously included in the index, including Germany’s currency, the Deutsche Mark, in 1999.
Specific currencies in the USDX may be replaced in the coming years if the index is required to represent the United States’ major trading partners. Because China and Mexico are important US partners, the yuan (CNY) and peso (MXN) could replace the Swiss franc and Swedish krona. In addition, the USDX could be expanded to include yuan and pesos.
How is the Dollar Index weighted?
The Dollar Index is weighted to reflect its worth in relation to the US dollar. Each currency’s value is multiplied by its weight in the index. The EUR is the USDX’s most important component, accounting for 57.6% of the basket. This is because the euro continues to represent ‘legacy’ European currencies that have all been replaced by the euro.
The other currencies in the basket are weighted as follows:
- JPY (13.6%)
- GBP (11.9%)
- CAD (9.1%)
- SEK (4.2%)
- CHF (3.6%)
History of the US Dollar Index (USDX)
The USDX was established in 1973, following the termination of the Bretton Woods Agreement. The central bank agreement facilitated monetary policy relations among independent states while also establishing commercial and financial ties between the United States, Canada, Western European countries, and Australia.
Following the abandonment of the Bretton Woods Agreement’s gold standard, the Dollar Index provided a method for markets to determine the value of the world’s reserve currency.
Since 1985, the index has been managed by the Intercontinental Exchange (ICE).
US Dollar Index highs and lows
The USDX had a base value of 100 when it first debuted in 1973. Since its inception, the values have been compared to this 100-number base. Throughout its history, the USDX has traded in a wide range.
It reached an all-time high of 163.83 on March 5, 1985, and a low of 71.58 on April 22, 2008. As of March 31, 2021, the index was at 93.26, which was less than the initial value of 100, indicating that it was undervalued in comparison to other currencies.
What moves the price of the US Dollar Index?
The USDX is influenced by macroeconomic events and data such as GDP economic growth, each country’s economic health, and the monetary and fiscal policies of each central bank.
Safe haven inflows are another significant influence on the price of the US Dollar index. The index may rise during times of uncertainty if traders regard the US dollar as a safe haven during global economic downturns. The index may fall if risk-on sentiment prevails and investors sell USD in favor of riskier assets.
How to trade the dollar index
The US Dollar Index can be traded similarly to an equity index. Instead of buying and selling multiple securities at the same time, you would only deal in one. In this case, instead of trading multiple US Dollar pairs, you can trade a single index that should rise and fall in tandem with the overall USD market sentiment.
The index is popular among FX traders who may not have the time to constantly monitor the movements of each USD pair throughout the day. Spreads and commissions can be competitive due to the volume of trading in the USD and index.
If the USDX rises, the US dollar gains strength against the basket’s other currencies. If the index is bullish, it is reasonable to assume that overall confidence in the USD (US dollar) is high.
You may also want to adjust your long and short positions based on whether the USDX is rising or falling. For example, if the index is bullish, you may want to reconsider any short positions in USD/JPY and USD/CHF.