What is the US Dollar Index and How to Trade It?

What is the US Dollar Index and How to Trade It?

Reading time: 5 minutes

Launched in 1985, the US Dollar Index remains widely followed among Forex traders as a measure of the strength of the US dollar (USD) against a basket of foreign currencies. 

To avoid misperception, the US Dollar Index can be referred to in several acronyms, including ‘DXY’ (pronounced 'Dixie') and ‘USDX’. Both are commonly used in everyday financial parlance; the DXY is the ticker symbol derived from Bloomberg’s terminal. As an additional note, the symbol ‘DX’ (followed by the month/code) is also used to refer to the futures contract for the USD Index.

Currency Basket

The US Dollar Index basket houses six international currencies. The euro (EUR) carries the highest weight within the index, at 57.6%, followed by the Japanese yen (JPY) at 13.6%, the British pound (GBP) at 11.9%, the Canadian dollar (CAD) at 9.1%, the Swedish krone (SEK) at 4.2% and the Swiss franc (CHF) at 3.6%. 

How is the US Dollar Index Calculated?

For those of you who are more math-inclined, the index is a geometrically average weighted formula of six exchange rates that are weighted against the US dollar. 

USDX = 50.14348112 × EUR/USD^-0.576 × USD/JPY^0.136 × GBP/USD^-0.119 × USD/CAD^0.091 × USD/SEK^0.042 × USD/CHF^0.036

An important thing to remember if attempting to manually calculate the index is to express all FX rates (the currency pairs above) in US dollar: the USD must always be the quote currency (you would need to invert the USD/JPY, for example, and then raise to the power of its weight). A notable shortcoming of the index weighting methodology is that there is no regular rebalancing of the index. According to research (Intercontinental Exchange [ICE]), the index has only been adjusted once and that was when the euro was introduced.

Assessing USD Strength 

In simple terms, a rising US Dollar Index means the USD is advancing relative to its six currency peers, and vice versa for a declining Dollar Index. With that, you will find that traders and investors use the index to assess the buck’s strength, particularly against the EUR. In view of its considerable weight within the index, an inverse correlation exists between the EUR/USD currency pair and the US Dollar Index. As shown in the daily charts below, when the USD Index rises, a corresponding fall in the EUR/USD is frequently observed, and vice versa for a falling USD Index. 

How to Trade the Dollar Index

The US Dollar Index is an index, like the S&P 500 or the Nasdaq, and cannot be traded directly. 

Fortunately, several dedicated instruments allow traders to trade the price movement of the index. This could simply be in the form of CFDs. These are Contracts for Differences offered by FP Markets, allowing clients to trade on the underlying price movement of the index without taking direct ownership of the underlying asset. 

In the case of the Dollar Index, or any index, you would never take ownership of the underlier as it is an index and not something like a physical commodity such as oil or wheat. However, you need to understand that all CFDs are cash-settled instruments, meaning that whether you are trading currencies, commodities or cryptocurrencies, all will be cash-settled trades with no physical settlement permitted (unlike in the futures and options markets). 

You can also simply trade the US dollar through currency pairs if you wish. For example, trading USD pairs like EUR/USD or USD/JPY directly reflects your view on the DXY's movement. In the case of the EUR/USD, if you were bullish on the dollar, you would enter short the currency pair as you short (sell) the base currency (EUR) and effectively simultaneously enter long (buy) the USD. 

Alternative ways of trading the Dollar Index are through Futures and Options contracts as well as Exchange-Traded Funds (ETFs).