In Forex trading, currencies are traded in pairs. The value of a currency is indicated relative to the value of another currency. Now, in the case of the US dollar index, the value of the US dollar is indicated relative to the value of a basket of currencies.
In 1973, the US Federal Reserve created the dollar index to track the greenback against a basket of a geometrically weighted average of six currencies, namely: the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona, and the Swiss franc. At the time of the creation of the US dollar index, the currencies of the countries that dominated the trade with the USA were used. Officially, the weightage of each of the currencies that make up the US dollar index is as follows:
Euro (EUR) – 57.6%
Japanese yen (JPY) – 13.6%
Pound sterling (GBP) – 11.9%
Canadian dollar (CAD) – 9.1%
Swedish krona (SEK) – 4.2%
Swiss franc (CHF)- 3.6%
At the beginning, the value of the US dollar index was 100. Since then, it has traded at a high of 164.72 (February 1985) and at a low of 70.698 (March 2008).
The math behind the US dollar index
The formula for the calculation of the US dollar Index is as follows:
DXY = 50.14348112 × EURUSD -0.576 × USDJPY 0.136 × GBPUSD -0.119 × USDCAD 0.091 × USDSEK 0.042 × USDCHF 0.036
If the US dollar is the base currency in a pair, then the weighing coefficient is positive. On the other hand, if the US dollar is the quote currency, then the coefficient of that pair would be negative.
Interpretation
»The value of the US dollar index enables a trader to understand whether the US dollar has strengthened or weakened against the basket of currencies and by how much.
»If the US dollar index trades at 125, then it means that the greenback has appreciated by 25% against the basket of currencies compared to the initial value. Likewise, if the US dollar index trades at 75, then it means that the greenback has depreciated by 25% against the basket of currencies.
»So, when the US dollar index is in a clear uptrend, a Forex trader should avoid taking a short position in the US dollar based currency pairs and vice-versa.
Conclusion
The US dollar index can be used as a quick reference guide to assess the strength of the US dollar against rival currencies. However, considering the huge investment required, it is arguably suited only for large traders. Still, it is worth to check out the index chart before entering into a trade as it will assist in avoiding wrong entries.
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