DXY - US Dollar Index for Forex
Forex trading is done in pairs. It shows the value of one currency against another. In the case of the US Dollar Index, the US dollar value is compared to a group of currencies. This text discusses the history and derivatives of the US Dollar Index (DXY), the implications and ultimately, how it can be useful for forex traders.
Historical Background
The Bretton Woods system was the international standard until the primary 1/2 1971. It is closely related to the 1940 gold standard system. This method saw the major currencies pegged to US dollars, which were then linked to Fort Knox's gold reserves. This system's inherent loopholes and Europe's shift towards free capital movement led to the system's collapse.
US President Richard Nixon announced unilaterally in August 1971 that the Bretton Woods system would be ended and that the direct international currency from US dollars to US gold would cease. Due to the nearly 3rd decline in the country's gold reserves. France demanded that the US dollar in its possession be converted into gold. This prompted the Americans and others to liberalize the exchange rate and float the dollar.
After the Bretton Woods system was ended, it became necessary to create a system to compare the value of the US dollar to other major currencies. The US Fed created the "dollar index" in 1973 to measure the performance of the US Dollar against six currencies. These were the Euro, Japanese and country yens, dollar, dollar, and Swedish monetary units. The US dollar index was created using the currencies of countries that control trade with the US. Also, the weighted rates of all currencies used to create the index were 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%
The US Dollar Index, created on January 1, 1999, by the Euro, was composed of 10 currencies. The Eurozone was created and resulted in a rebalancing or adjustment of the currencies that make up the DXY Dollar Index. Even though these currencies are no longer the most traded with the US dollars, there have been no major changes.
The Mathematical Formula Behind the US Dollar Index
This is how to calculate the US Dollar Index:
DXY = 50.14348112x EURUSD 0.136x GBPUSD 0.19x USDCAD 0.091x USDSEK 0.042x USDCHF 0.036
The US dollar is the base currency of the pair. This means that its weight coefficient will be positive. The correlation coefficient is negative if the US dollar is the quoted currency.
Interpretation
The US dollar index's value allows traders to gauge the dollar's strength against a basket of currencies and the magnitude of these ups and downs. The US dollar index trading at 75 means that the dollar has declined by 25% against a basket currency. Forex traders should avoid short positions when the US Dollar index is in an extremely clear uptrend.
Trading The US Dollar Index
Futures on the US dollar index are traded on Intercontinental Exchange (ICE). The most widely recognized currency index is the US dollar index. It is worth noting, however, that futures contracts were introduced to trading for the first time on November 20, 1985.
Trading began with US dollar index options on September 3, 1986. Both options and futures are only available for electronic trading via the ICE platform. The DX represents futures contracts (SDXmini futures contracts), followed by the year and month codes.
Multiple data feeds from Forex are used to update the price once every 15 seconds. The middle point is where the bid/ask quotation is used to calculate the US Dollar index. This information is then passed to various data vendors. Some data vendors may use their codes.
Bloomberg, for example, uses the symbol DXY (known as Dixie). The contract allows trading to begin at 18:00 ET on Sunday and end at 17:00 ET on Monday. The market reopens on Sunday at 8:00 ET and closes on Tuesday and Friday at 17:00 ET. Traders can place orders for trading during the pre-open window (30 minutes before trading/order execution).
Another benefit is the ability to hedge against volatility in the US dollar with derivatives contracts. The ICE Dollar Index contract, which allows transparent price discovery and shares to be traded on a regulated exchange, is the only derivative instrument. Based on individual ability, US Dollar Index derivatives can only be traded by major realty and hedge fund investors who work with investment banks.
The US dollar index futures contract size equals 1,000 times the index value. For example, $96,550 is the contract size for a US dollar index trading at 96.550. The smallest price movement is 0.005, with a value of $5. The contracts have a quarterly expiration period - March, June and September, September, and December.
The daily settlement is based on the average quantity weighted price for all trades during the closing period (14.59-15:00 Eastern Standard Time). The smallest price movement is 0.005 in size, but the settlement price is added as an additional 0.001.
The Chicago Board of Trade (NYBOT), a subsidiary of ICE, is authorized to offer US dollar index futures contracts. DXY can also be traded through ETFs, Exchange Traded Certificates (ETFs), and fund units via various exchanges.
Trade-Weighted US Dollar Index
The Federal Reserve System created an alternative to the US dollar index in 1998 to help create the most relevant index for the current economic situation. The index had to include the currencies of countries like Brazil, China, and Mexico. These countries are increasingly important in international trade with the USA. The second reason was that the US dollar index became obsolete due to the introduction of the Euro. This new index is either the trade-weighted US Dollar index or the broad spectrum index.
Other Differences
We can see that the US dollar index does not reflect the establishment's currency composition. ICE charges a small fee for instant and delayed offers.
Market makers will find it more expensive to calculate the US dollar index using the weighted average value. The chart of the US Dollar Index looks almost exactly like the inverted chart for eurodollars.
The difference in weight suggests that the impact of the Euro on the US dollar index is greater than that of other currencies. However, this may not always be true (for instance, the Bank of Japan will not create an equivalent effect on the US dollar index value with another round of monetary ease by the EU financial institutions).
FXCM and Dow-Jones Industrial Average have created the DJ FXCM Dollar Index, despite the flaws. The index includes 4 major currencies: the Euro, the Australian dollar and the yen. Each currency is given a 25% weight.
This allows traders to track their trading positions in one of the four currencies. You can also trade the indicator on FXCM's trading platform.
Conclusion
The US Dollar Index is a quick reference tool that will help you compare the strength of the US Dollar to other currencies.
It is often stated that the US Dollar Index is not suitable for high-level traders due to the large investment required. You should always check the indicator chart before you enter a trade to prevent false entries.