How to Read the U.S. Dollar Index

Here’s a chart of the U.S. Holler at the Dollar Index:

First, notice that the index is calculated 24 hours a day, seven days a week. The USDX measures the dollar’s general value relative to a base of 100.000. Huh?!

Okay. For example, the current reading says 86.212. This means that the dollar has fallen 13.788% since the start of the index. (86.212 - 100.000).

If the reading was 120.650, it means the dollar’s value has risen 20.650% since the start of the index. (120.650 – 100.00)

The start of the index is March 1973. This is when the world’s biggest nations met in Washington D.C. and all agreed to allow their currencies to float freely against each. The start of the index is also known as the “base period”.

The U.S. Dollar Index Formula

This is strictly for the grown and geeky. Here is the formula to calculating USDX:

USDX = 50.14348112 × EURUSD^(-0.576) × USDJPY^(0.136) × GBPUSD^(-0.119) × USDCAD^(0.091) × USDSEK^(0.042) × USDCHF^(0.036)

"The key to everything is patience. You get the chicken by hatching the egg, not by smashing it open."

The USDX Components

Now that we know what the basket of currencies are, let’s get back to that “geometric weighted average” part. Because not every country is the same size, it’s only fair that each is given appropriate weights when calculating the U.S. Dollar Index. Check out the current weights:

As you can see, with its 12 countries, euros make up a big chunk of the U.S. Dollar Index. The other five make up less than 43 percent.

Here's something interesting: When the euro falls, which way does the U.S Dollar Index move?

The euro makes up such a huge portion of the U.S. Dollar Index, they might as well call this index the "Anti-Euro Index". Because the USDX is so heavily influenced by the euro, people have looked for a more "balanced" dollar index. More on that later though. First, let's go to the charts!

"I know the price of success: dedication, hard work, and an unremitting devotion to the things you want to see happen."

Frank Lloyd Wright

What is the U.S. Dollar Index?

If you’ve traded stocks, you’re familiar with all the indices available such as the Dow Jones Industrial Average (DJIA), NASDAQ Composite Index, Russell 2000, S&P 500, Wilshire 5000, and the Nimbus 2001. Oh wait, the last one is actually Harry Potter’s broomstick.

Well if U.S. stocks have an index, the U.S. dollar can’t be outdone. For currency traders like us, we have the U.S. Dollar Index (USDX).

The U.S. Dollar Index consists of a geometric weighted average of a basket of foreign currencies against the dollar.

Come again?! Okay before you fall asleep on us after that super geeky definition, let’s break it down.

It’s very similar to how the stock indices work in that it provides a general indication of the value of a basket of securities. Of course, the “securities” we’re talking about here are other major world currencies.

The Basket

The U.S. Dollar Index consists of six foreign currencies. They are the:

1. Euro (EUR)
2. Yen (JPY
3. Cable (GBP)
4. Loonie (CAD)
5. Kronas (SEK)
6. Francs (CHF)

Here’s a trick question. If the index is made up of 6 currencies, how many countries are included?

If you answered “6”, you’re wrong. If you answered “17”, you’re a genius.

There are 17 countries total because there are 12 members of the European Union plus the other five (Japan, Great Britain, Canada, Sweden, and Switzerland).

It’s obvious that 17 countries make up a small portion of the world but many other currencies follow the U.S. Dollar index very closely. This makes the USDX a pretty good tool for measuring the U.S. dollar’s global strength.

"When you go in search of honey you must expect to be stung by bees."

What is the U.S. Dollar Index?

If you’ve traded stocks, you’re familiar with all the indices available such as the Dow Jones Industrial Average (DJIA), NASDAQ Composite Index, Russell 2000, S&P 500, Wilshire 5000, and the Nimbus 2001. Oh wait, the last one is actually Harry Potter’s broomstick.

Well if U.S. stocks have an index, the U.S. dollar can’t be outdone. For currency traders like us, we have the U.S. Dollar Index (USDX).

The U.S. Dollar Index consists of a geometric weighted average of a basket of foreign currencies against the dollar.

Come again?! Okay before you fall asleep on us after that super geeky definition, let’s break it down.

It’s very similar to how the stock indices work in that it provides a general indication of the value of a basket of securities. Of course, the “securities” we’re talking about here are other major world currencies.

The Basket

The U.S. Dollar Index consists of six foreign currencies. They are the:

1. Euro (EUR)
2. Yen (JPY
3. Cable (GBP)
4. Loonie (CAD)
5. Kronas (SEK)
6. Francs (CHF)

Here’s a trick question. If the index is made up of 6 currencies, how many countries are included?

If you answered “6”, you’re wrong. If you answered “17”, you’re a genius.

There are 17 countries total because there are 12 members of the European Union plus the other five (Japan, Great Britain, Canada, Sweden, and Switzerland).

It’s obvious that 17 countries make up a small portion of the world but many other currencies follow the U.S. Dollar index very closely. This makes the USDX a pretty good tool for measuring the U.S. dollar’s global strength.

"When you go in search of honey you must expect to be stung by bees."

How to Use the COT Report

Because the COT report is published weekly, it would be more suitable for longer term traders to use as a market sentiment indicator. So, how do we do that? Well, besides using the changes in open interest and changes in the number of long and short contracts as a volume indicator, my favorite way to use the COT report is to find extreme net long and net short positions. This can be great indicator that a market reversal is around the corner because if everyone is long a currency, who is left to buy? No one. And if everyone is short a currency, who is left to sell? Again, no one. The only thing a market can do is go the other direction. Here’s a chart example:

This is an example chart of the US Dollar Index from freecotcharts.com. In the top half of the chart we have the price action of the USD index futures with each bar representing weekly data. On the bottom half of the chart we have data on the net long/short positions broken down into three categories: Commercial (Blue), Large Non-commercial (Green), and Small Non-commercial (Red). We will pay attention to the Large Non-commercial positions since commercial positions are for hedging and small retail traders aren’t really a factor.

Let’s examine this chart and see what it can tell us. We can see that the US Dollar began a nice little bull run at the start of 2005. As the value of the net long positions of large speculative traders (green line) rose, so did the price of the USD futures index. In the first week of July 2005, net long positions grew to over 20K contracts. This was an extreme area of longs and soon after the market began to sell off USD index futures. The USD index price dropped from 91 to 86, but it only proved to be a retracement as the index rallied to a new high of about 93.16 and higher level of 29K net long contracts.

As you have probably already asked yourself, “with this many longs who is left to buy?” Not too many traders really. With the market appearing overbought in November 2005, we began to see the number of long USD index futures contracts decline and a drop in the index price from 93 all the way down to about 84. Wow, can you imagine if you positioned yourself before this move?

By now I bet you’re asking, “I trade the spot forex market not futures. How does this apply to my trading?” Great question! Since we’re already taking a look at the US Dollar, let’s look at one of the best vehicles to trade the Greenback in the spot forex market: EUR/USD.

Here’s a weekly chart of EUR/USD:

If we had applied what we learned in the previous section by positioning ourselves for market reversals, we could have caught two significant moves from July 2005 to May 2006 in EUR/USD.

First, in July 2005, if a trader saw the extreme levels of net longs in the USD index futures, this trader would catch the possible upcoming selloff of the Greenback by buying EUR/USD. This trader would’ve been proven right, and paid off handsomely as this position could have caught a maximum of 700 pips. Again, if this trader were so astute to catch the extreme level of long USD index futures contracts in November 2005, buying EUR/USD would have been the best bet as the pair rallied from about 1.1650 to almost 1.3000….wowzers!!! That’s over 1300 pips gained! So, from July 2005 to May 2006, a trader could have caught almost 2000 pips just using the COT report as a market reversal indicator. Pretty good, eh??

"Obstacles are those frightful things you see when you take your eyes off your goals."

Henry Ford

Commitment of Traders Report

The Commodity Futures Trading Commission publishes the Commitment of Traders report (COT) every Friday, and it measures the net long and short positions taken by traders in the futures market. It is a great resource to gauge market sentiment from the “big players” because of their large positions they are required to report to the government. Of course, it is very important to see what the “smart money” is up to because they move the markets and it may have an impact on your positions.

Below, we have an example of the Swiss Franc COT report taken from August 22, 2006 Check it out:

The report is pretty straight forward, but here’s a quick run down of what each category is.

• Non-Commercial - This is a mixture of individual traders, hedge funds, and financial institutions. For the most part, these are traders who looking to trade for speculative gains.

• Commercial - These are the big businesses that use currency futures to hedge.

• Long - number of long contracts reported to the Commodity Futures Trading Commission (CFTC).

• Short - number of short contracts reported to the CFTC.

• Open interest- this column represents the number of contracts out there that have not been exercised or delivered.

• Non-reportable positions;- These are the open interest positions of traders that do not meet the reportable requirements of the CFTC.

• Number of traders- total number of traders who are required to report positions to the CFTC.

• Reportable positions;- the number of options and futures positions that required to report according to CFTC regulations.

In the center of the report we see “CHANGES FROM 08/15/06.” This section shows the change in Open Interest and the changes in the Long and Short positions from the previous week.

"A superior man is modest in his speech, but exceeds in his actions."

Confucius

Getting Sentimental with Forex Trading

Sentimental analysis is what it sounds like – gauging the market sentiment. What does that mean? Well, as traders, a part of our job is to determine if a market is bullish, bearish, overbought, oversold, and to plan a trade for those market conditions – basically putting all of the things we’ve learned up until this point all together.

So how do we do that? What tools can we use? And how do we react to certain conditions? Well, that’s what we’re going to find out today – we’re going to take a look into sentiment analysis in forex trading.

Now there are a couple of ways to gauge different market conditions. Does anyone know what those two things are? You guessed it: technical and fundamental analysis. Now, in the School of Pipsology, we’ve covered most of the commonly used technical indicators out there for forex trading, so you should be an expert at that already right?

But how about the fundamental tools? What fundamental tools are available to gauge sentiment?

Well, in stocks and options, sentiment is measured using volume data. For instance, if a declining stock suddenly reversed on high volume that means the market sentiment may have changed from bearish to bullish. Or if a stock price was rising on gradually declining volume, then that may be a sign of an overbought market.

But have you ever seen volume data on any forex charts?

Probably not.

Being that the foreign exchange does not have a centralized market, volume data cannot be accurately calculated. So, where’s a trader to go to get such valuable data? That’s where the COT report comes in.