How to Use the US Dollar Index for Trading
BY Chris Andreou
|1 18, 2022The US Dollar index is one of the most popular indices for forex traders. You can trade the US Dollar index directly or you can use it indirectly as an indicator to help you make trading decisions.
Using this index can provide you with insights into the strength or weakness of currency markets that involve the US Dollar.
Keep reading to learn how you can use the US Dollar index for trading.
Let’s get started.
Create an MT4 or MT5 trading account to get access to the US Dollar index chart.
What is the US Dollar Index
The US Dollar Index, also called the “USDX” or the “DXY” or “DXA”, is an index that tracks the strength or weakness of the United States Dollar against six other major currencies. These currencies that make up the basket are the Euro, British Pound, Japanese Yen, Canadian Dollar, Swedish krona and Swiss franc.
It measures the value of the US Dollar against a weighted average of these six currencies and the Euro is the largest component currency that makes up the basket.
The US dollar index is available for trading on most brokers platforms or it can be used as an indicator to help you make trading decisions in other foreign exchange or financial markets.
What makes the US dollar index tick?
The currencies used to calculate the Dollar index are themselves traded actively throughout the day. As they are being traded, their values are subject to change due to the dynamics of supply and demand.
The Dollar index is calculated from the average weighted performance of these currencies relative to the US Dollar. So as the US Dollar rises or falls relative to this basket of currencies, so too does the value of the index.
The index is expressed in terms of points rather than a conversion ratio like conventional exchange rates. So when the index is rising, it means that the US Dollar is strengthening relative to the basket of foreign currencies. When the index is falling, it means that the basket of foreign currencies is strengthening relative to the US Dollar.
Where to find the US Dollar index
It can be found on the trading platform in the market watch window. If it is not visible there, you can add it for display in the same way as you would add any other symbol.
This is how to do it.
- Create your trading account and download the MT4 or MT5 platform
- Log in to the platform, then right click anywhere in the market watch window.
- Select show all from the pop up menu that appears.
- Scroll down the list of symbols until you find “DXA”.
- Right click on the DXA symbol and select chart window to open the chart.
When and how to use the index
The dollar index is used by forex traders as an indicator to help them find trading opportunities in other currency pairs. The purpose of following this index is to help with determining if the US dollar is likely to strengthen or weaken against foreign currencies.
It helps you determine a directional bias and whether you might want to be a buyer or seller of the USD.
But unlike other indicators, this indicator can be traded directly because it is an index. So once the analysis has been done, a trader can either execute a trade on the index or get a directional bias to trade another currency that is paired with the USD.
Let’s look at an example.
Trade the index directly
This is a 1 hour chart of the US Dollar index and it shows us that after a downtrend, the index started trading within a consolidated range for the past 4 days.
While the index is consolidating in this range, it is fair to assume that not much movement is to be expected in currencies paired with the USD or the index itself.
It’s not until the consolidation period ends and the support or resistance area is convincingly broken that the market might see a significant strengthening or weakening of the USD. However, there might be some short term trading opportunities at the upper and lower boundaries of the range.
So this range could help formulate trade ideas, either a trade can be initiated in the index or in another currency pair that involves the USD.
Trade another currency paired with the USD
When the index approaches a support or resistance area, an opportunity to buy or sell currencies paired with the USD might be available. If the index holds at support, then you might anticipate a stronger USD, which could mean an opportunity to short EURUSD or the GBPUSD.
Shorting either of these two currency pairs involves selling the base currency to buy the quote or counter currency, or in other words, buying USD and selling either EUR or GBP.
If the support or resistance area doesn’t hold, and a break out of the range occurs on either side, then the opposite trade to the above could be considered.
That’s how the US Dollar index can be used in basic terms, but if it is going to be used as an indicator, it would be best to buy or sell the USD versus the strongest or weakest foreign currency in the basket.
Here is an example using the EURGBP to demonstrate how you can determine that.
These two currencies are in the basket of currencies used to calculate the US Dollar index. By analysing the EURGBP currency pair, a trader can first determine the directional bias and establish which of the two currencies is likely to be the stronger or weaker one.
Then with this knowledge, you can buy or sell the EURUSD or the GBPUSD, whichever is stronger or weaker in relation to the strength or weakness of the US Dollar.
With that being said, it is not mandatory but I will elaborate further to help things make more sense.
If you have established that the USD is likely to be weak from analysing the US Dollar index, the next step is to determine which of the foreign currencies is more likely to be the strongest.
The reason why it’s beneficial to do this is because it will give you the highest probability of capturing a more significant price move. Since, you will be simultaneously selling a weak currency to buy a stronger one.
So you can look at the basket of currency pairs against themselves, or any other foreign currency pairs to help you find out. Then take the strongest one and trade that relative to the USD. If you think that JPY is the stronger currency of all the currency pairs, then execute a sell on the USDJPY currency pair.
Why You Should Use the Dollar Index
The US Dollar Index is often referred to as a barometer of USD health. It is a useful tool to indicate potential strength or weakness in the US Dollar relative to other currencies in the foreign exchange market.
Some traders also use USD index as a way to try to hedge risk – for example, you might be long several foreign currencies against the dollar but think the USD might strengthen. Instead of hedging in all these currency pairs, a single position can be initiated in the index.
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