What Is the US Dollar Index (USDX) and How to Trade It

Changes in the strength of the US dollar leave their imprint on the stock market, the bond market, the commodities market, and the foreign exchange market. For this reason, economists have a strong interest in gauging any trends that may be guiding the dollar’s power. If the dollar is riding a strong uptrend that shows signs of continuing, the financial trading decisions of millions of people could be affected. Similarly when the USD is heading into a nosedive: All the financial markets will register the impact and traders will react accordingly.

Since commodities like oil are priced in USD, a dip in the dollar is likely to push up oil prices. This could heat up inflation and alter the spending decisions of American consumers. People might cut down on discretionary purchases like electronics and leisure, which would affect a whole range of companies that operate in these fields.

On the other hand, a weak dollar brings about certain benefits too. US multinational corporations that collect their revenue overseas – for instance McDonalds, General Motors, and Boeing Co. – will wind up with more dollars on their hands when they return their earnings to American soil. This could give them a big boost. In addition, American exporters tend to find their goods briskly snapped up in such times since those goods will be cheaper for foreign currency holders.

When we look at the value of the EUR/USD currency pair (which measures the euro against the dollar) in September 2007, we see it touched on 1.41 (meaning that it cost $1.41 to but one euro), which was a historically low value for the USD against the euro. Yet, from this information alone, we wouldn’t know the USD had embarked on a broad-scaled nosedive against all its main forex partners, as a result of which all sorts of economic consequences could be anticipated.

To get that information, we would have to consult the US Dollar Index (USDX), which measures the USD against six of its major currency competitors. In 2007, the USDX registered an extremely low reading of only 70 (compared with a base of 100), which informed strategists about that larger weakening trend. In this article, we’ll elaborate on this popular gauge of US dollar strength, explaining what drives it one way or the other, but also touching on the ways traders use the USDX in their forex trading strategies.

What Makes a Strong Dollar?

In the latter part of 2023, the United States imported considerably more goods from foreign nations than it exported to them. October alone saw the difference between her exports and imports – called the trade deficit – increase by 5.1%. One reason for this was that US products were less appealing in those months due to the strong dollar, which inflated their prices for international purchasers. As a result of this state of affairs, the US economy was left on shaky footing.

When this happens, it means US dollars are heading out of the United States in greater quantities than the foreign currencies heading into the country. It also means American assets – whether they are stocks, bonds, or property – are less in demand in the global marketplace. The natural consequence, if all things remain equal, will be for American currency to lose value.

However, if the economy remains strong for other reasons, this need not happen. This is because the vibrant economy proves irresistible in its own right for foreigners seeking returns on their funds. A case in point occurred in 1984 when the US trade deficit actually set a new record at $123.3 billion, but this didn’t stop the dollar from crushing its competitors in the forex market. Speaking of records, the USDX marked a fresh one of its own in that year, checking in at a giant 165. What powered this bull run in the dollar, in the face of the dragging influence of the trade deficit, was the fact that Europeans and Asians believed America’s economy would outdo their own economies for the foreseeable future. This sealed the deal as far as they were concerned, convincing them to send their capital into US assets, which propelled the dollar higher.

Trading Sentiment

The USD is unique among national currencies in that it proves attractive even in times when the American economy is puttering along weakly. The reason is that it is viewed in trading circles as a safe haven, meaning that it is likely to retain its value in times when uncertainty clouds the national or world economy. It follows that a slow US economy does not necessarily mean a weak dollar.

This is not to say the dollar is always strong. When unemployment is high and Americans have to consume less, the sluggish state of the economy can convince traders to sell their American assets. Their course of action in such times is to plant those assets back in their local currencies, and this will be bearish for the USD. But how can we know when one of these waves of bearish sentiment is creeping over the forex market?

One way is through sentiment indicators, which give you the proportion of trades on a particular currency taking long or short positions. For example, they can tell you that, when it comes to a popular currency pair like the EUR/USD, 85% of trades on the market are short (meaning they are premised on a strong dollar) and 15% are long (anticipating a surge in the euro). In a case like this, with such extreme one-sidedness in the direction of the short trade, traders will infer that the trend may soon reverse so that the euro will gain ground over the dollar. The reason is that the supply of new short traders needed to keep the pro-dollar trend going is running – well, short. Forex traders will usually wait to see the reversal start to happen before acting on their sentiment indicator.

Trading the USDX and Dollar Index Charts

Parallel to sentiment indicators in their role of gauging dollar trends is the US Dollar Index. Instead of telling you how many trades are going long on the dollar, the USDX gives you a broad picture of how the USD is fairing in its matchups against its currency partners. By tradition, those six currencies are established as the euro, the Japanese yen, the British pound, the Swiss franc, the Canadian dollar, and the Swedish krona.

These six currencies are not weighted equally in their make-up of the USDX, and this makes a marked impact on your forex trading in the dollar pairs. Most significantly, it’s noteworthy that the euro grabs the lion’s share (57.6%) of that measure of the dollar. It follows that the EUR/USD – which gains in value when the dollar weakens against the euro – stands in an inverse relationship with the USDX. When the USDX shoots up, it invariably means the dollar is strengthening against the euro, and this may push down the EUR/USD. Thus, traders’ natural reaction in such times will be to sell that pair. By contrast, when the USDX takes a dip, there is reason to buy the EUR/USD. This dynamic also works in the opposite direction: When the euro strengthens against the dollar, the USDX will feel downward pressure.

Whether it’s in order to trade the EUR/USD or any of the other dollar pairs like USD/JPY or the GBP/USD, the US Dollar Index provides traders with a reliable impression of the trend guiding the dollar at the moment. By comparing the USDX figure with its standard level at 100, traders are able to perceive that the USD is, either in the process of rampaging over all challengers, or, alternatively, in a period of nursing its wounds. This helps them figure out which position on the dollar would fit the mood of the moment: a buy or a sell deal. You can also peruse a US dollar Index chart in order to appreciate a fuller history of the dollar’s present guiding trend, whether it’s bullish or bearish. For example, a dollar index chart can track the struggle of the USD with its competitors over the period of a full year. The visual representation of the chart can enhance your understanding of the present drift of dollar prices and where it may lead.

Take note of the fact that, if your currency pair of interest features the dollar as the base currency, like the USD/JPY, it will tend to move in direct proportion to the USDX. This means that a surge in the USDX will probably boost the value of the USD/JPY, suggesting that a long deal on the pair would be appropriate. If, however, your currency pair features the USD as the quote currency, like the GBP/USD, the opposite will be the case: A rise in the USDX will signal a drop in the value of the pair, making a short deal appropriate. This is because a pair like the USD/JPY is essentially a measure of the dollar itself – in terms of the Japanese yen. The GBP/USD, by contrast, describes the value of a different currency – the British pound – in terms of US dollars.

Summing Up

We have seen how the value of the dollar is integral to all of the world’s financial markets, and that fluctuations in that value lead to many kinds of knock-on effects in the economy. For those who are focused on forex trading with US dollar pairs, the effects are, perhaps, most direct. These people need to find ways of assessing the waves of sentiment pushing and pulling the USD in the markets – in order to know which direction their deals should take. Sentiment indicators are one tool they use in this regard, and the US Dollar Index is another, especially in its incarnation as a dollar index live chart.

Beyond these two, there is a range of technical indicators that can be applied to dollar-pair price charts. These specialized devices are geared to tell us what sorts of price activity have tended to follow from present circumstances in the past. Technical analysis ignores what forex traders are doing now with respect to a given currency pair (the focus of sentiment indicators), and it isn’t interested in the overall strength of the dollar against its competitors (like the USDX is). Rather, it views future price action as part of a cyclical trend pattern that is destined to repeat itself. To figure out what the dollar will do next, they believe we need only properly understand what it has done until now.

Strategists advise using more than one sort of indicator in your forex trading strategy. Ultimately, through experience and ingoing study, you’ll decide how to weigh each indicator in your personal approach to the market.