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How to Trade US Dollar Index: Trading Strategies & Tips

How to Trade US Dollar Index: Trading Strategies & Tips

Richard Snow, Markets Writer
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Trading the Dollar Index (DXY) is a valuable skill as it’s one of the most popular currency indexes worldwide. In this guide we explore the best tips and strategies for using the dollar index to trade forex, including an overview of the Dollar Smile Theory and Dollar Index trading hours.

What is the US Dollar Index and why trade it?

The Dollar Index measures the performance, or value, of the US Dollar versus a basket of foreign currencies. These are trading partners to the US and include the Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc.

Since it is an index, the USD index functions similarly to the FTSE 100 or NYSE but, instead of being a barometer for the health of the equity market, it shows the relative strength of the US Dollar. The index is maintained and published by Intercontinental Exchange Inc (ICE) and is calculated every 15 seconds.

Currencies that make up the US Dollar Index

Currency

Weight

Euro (EUR)

57.6%

Japanese Yen (JPY)

13.6%

British Pound (GBP)

11.9%

Canadian Dollar (CAD)

9.1%

Swedish Krona (SEK)

4.2%

Swiss Franc (CHF)

3.6%

Source: Bloomberg data

Why trade the US Dollar Index?

The US Dollar is the world’s reserve currency, which means that it is widely traded and attracts interest from traders all around the globe. It is also an ideal currency to gain exposure to the forex market as it appeared on one side of 88% of forex trades in April 2016, according to the 2016 BIS Triennial Central Bank Survey.

The US Dollar has a rather unique characteristic in that it has the tendency to rise in times of global market uncertainty, but also when the US economy is thriving. As a result, the US Dollar forms long and well-established trends that skilled traders are able to take advantage of. The remainder of this article focuses on how to trade such trends and introduces the Dollar Smile Theory which provides an explanation for the existence of trends in the US Dollar.

US Dollar Index Trading Strategy

There are many different strategies that traders employ when trading the Dollar Index and these will vary depending on the type of trader and the strategy implemented. The most widely used trading strategies incorporate the use of trends, channels, price action (candlestick analysis) and breakouts. Keep reading to find out more about these strategies and how trend trading can help traders get into and out of higher probability trades.

Trend Trading the US Dollar Index (DXY)

Being the world’s reserve currency, the Dollar tends to form long and well-established trends. Trend trading is one of many strategies adopted by forex traders looking for signals to enter the market in line with the dominant trend.

In the chart below, it is clear to see the long periods where a trend has established itself. This is characterised by periods of higher highs and higher lows (the upward sloping green line) and long periods of lower highs and lower lows (the downward sloping red line).

US Dollar Index showing periods of well-established trends (August 2016 – November 2018)

How to Trade US Dollar Index: Trading Strategies & Tips

A common approach to trend trading involves identifying the long term trend and then looking for ideal entry points with the use of an indicator, using a smaller time frame or simply by reading price action.

For example, the chart below shows confirmation of a downtrend after the US Dollar market topped. This downtrend forms by observing lower highs and lower lows, as indicated by the blue circles. Confirmation of the downtrend occurs when the market trades to a lower low after producing a lower high. At this point, only trades in the direction of the trend should be considered. This is particularly important when using an indicator because an indicator has no concept of trend and may provide weak signals if not filtered with the trend’s direction.

Confirmation of downtrend on US Dollar Index (Daily chart)

How to Trade US Dollar Index: Trading Strategies & Tips

Swing tradersmake use of multiple time frame analysis when looking to time their entries into a trade. The longer time frame (daily chart) allows the trader to establish the overall trend. Zooming in on the chart using a smaller time frame (four-hourly chart), will provide the trader with higher probability entry signals when they are aligned with the trend.

Now that the downtrend has been established, we can look for entries to sell (depicted in the red zone).

US Dollar Daily chart highlighting the zone applicable for short trades

How to Trade US Dollar Index: Trading Strategies & Tips

The chart below shows the red highlighted zone using the four-hour chart and incorporates the stochastic indicator to provide entry signals. The stochastic provides many entry points which is why it is essential to filter these signals in order to achieve higher probability trades.

Stochastic indicator providing possible entry points (4 hour chart)

US Dollar Index using a stochastic indicator to spot ideal entry point

Checklist when using the stochastic to enter trades:

  1. Trend: Only consider signals that are in the direction with the current longer-term trend.
  2. Crossovers: Look for the trigger point when the %K line crosses the lagging %D line. This indicates that momentum is slowing down and could change direction.
  3. Extreme Levels: To enhance the strength of the signal, only consider crossovers at extreme levels i.e. when the market is overbought (above the 80 level) and oversold (below the 20 level).

In this example, we would only consider entries corresponding with the red circles on the stochastic indicators and should disregard the buy signals (grey circles) as these signals move against the current trend.

As always, it is important to make use of sound risk and money management before entering a trade to ensure your account is able to withstand losing trades along the way.

Typically, after traders enter the market, they place a stop loss just above the recent swing high for a short trade or just below the swing low on a long trade. Where exactly, a trader enters the market, will differ from trader to trader but there are several essentials that should be implemented consistently. One such essential is that the take profit and stop losses should be placed in accordance with a positive risk to reward ratio which can be a 1:1 or preferably, 1:2 if possible. For example, if the distance from entry to the stop loss is 50 points, then the take profit target should be 100 points away from the entry level in a 1:2 risk to reward set up.

Additionally, it is prudent to keep individual trades to a maximum of 1% of the trading account. This is a simple way to ensure that only high probability trades are entered into and has the added benefit of absorbing losses along the way without jeopardising the trading account.

The Dollar Smile Theory as a long-term trading strategy

The Dollar Smile Theory was first observed by Stephen Jen, a former currency strategist and economist at Morgan Stanley. It attempts to explain why the US Dollar strengthens in periods when the US economy is thriving, as well as, in periods of worsening global economic conditions. The pattern resembles a smile and plays out in three stages, as shown below.

US Dollar showing swings in trends over time

Stage 1: Fear drives investors towards the less risky US Dollar

When investors become risk averse they will often turn to “safe havens” such as gold, or in this case, the US Dollar. The surge in USD purchases drives the price of the dollar up.

Stage 2: USD weakens to new lows (weak US economic conditions)

The lowest point in the smile reflects a weaker US Dollar as a result of strained fundamentals. Sluggish economic growth could invite interest rate cuts, further weakening the currency.

Stage 3: US Dollar strengthens due to economic growth

The smile is completed as signs of an economic recovery appear. Investors buy into the Dollar once more, causing an increase in the value of the US Dollar

Dollar Index trading hours

US Dollar Index Futures trade 21 hours a day on the Intercontinental Exchange (ICE) and can be traded through an online forex, CFD and spread betting broker (where allowed).Trading hours may vary slightly across brokers but typically trades in line with the futures as produced below.

Open *

Close

ICE US Dollar Index Futures trading hours

ET

20:00

17:00 (next day)

GMT

01:00

22:00 (next day)

*The official GMT open starts at 23:00 on Sunday and closes for the week at 22:00 on Friday. Official ET open starts at 18:00 on Sunday and closes for the week at 17:00 on Friday.

More tips to trade the US Dollar Index

At DailyFX we have many resources to help you improve your trading:

  • If you are just starting out on your trading journey it is essential to understand the basics of Forex trading in our free New to Forex trading guide.
  • At DailyFX we researched over 100,000 live IG Group accounts to find out the secrets of successful traders and published the findings in our Traits of Successful Traders.
  • Stay up to date with major news events and economic releases by viewing our economic calendar.
  • We host multiple webinars throughout the day, covering a lot of topics related to the US Dollar like central bank movements, US Dollar news, and technical chart patterns being followed.
  • Successful trading requires sound risk management and self-discipline. Find out how much capital you should risk on your open trades.

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