US Dollar Index – Why Use It With Forex?

Posted in: Advanced Trading Strategies, Trading Article

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If you trade Forex, you don’t need anybody to tell you that many of the popular currency pairs are in conditions at this time that can be tough to trade.

Yes, you can emotionally trade and maybe get a winner, but for the past several weeks, finding great reasons to trade haven’t existed.

There’s been choppy price action, low volatility, momentum appearing and disappearing, and all of that combined does not make our job easier.

There is a tell-tale sign that conditions are not great and for that, we can look at the US Dollar Index.

 

Dollar Index – Barometer Of Stormy Trading Conditions

For those of you that are unaware, the US dollar index measures the USD against a 6 other currencies.  Inside that basket, the EURUSD makes up the bulk of the measure.

The top 3 currency pairs inside the basket are:

  1. EURO
  2. Japanese Yen
  3. British Pound

Those currency pairs are matched up against the USD and form the bulk of the trading activity that happens in Forex.

The Dollar Index is a good barometer of the strength or weakness of the USD against other currency pairs although the trade weighted Index, it could be argued, is more relevant to the true strength of the USD.

Adding the knowledge of the technical conditions of the Dollar Index can be part of your overall trading plan and help you assess which direction you wish to trade.

US DOLLAR INDEX CHART
US DOLLAR INDEX CHART

This the YTD US Dollar Index chart and we can see that in the beginning of the year, the USD was weak against the basket of currency pairs.  Price action trend pattern is showing lower highs and lower lows.  You can also see that any price consolidations resolved to the downside.

If you bring up the EURUSD or GBPUSD Forex charts, you will see that the drop in the USDX coincided with an up-trending market in those pairs.  There were some great trading opportunities regardless of your approach – unless you were picking tops – and price was trending well.

The weather shifted in early February.

Upside momentum stepped in showing the USD getting stronger as price began its rally.

If price would have kept moving, trading conditions would have continued to be fairly decent but markets are never affected by what we want.

 

USDX Price Action Sends A Warning

If you are familiar with technical analysis, trending markets make a stair step pattern but as you can see in the Index, price sold off, failed to make a lower low, and got trapped between the extremes.

This is when trading Forex (any market) becomes a little more difficult.

EURUSD FOREX
EURUSD DAILY FOREX CHART

When higher time frames are trapped between two extremes, lower time frame chart usually have some trending moves that you can trade.

For longer time frame traders, like myself, while the first rally back to resistance was a good trade, the wheels came off of the market especially for those who focus on the trend.

The market is still in an uptrend mode on the higher time frames but the larger range with the range inside that range, made the price moves less “reliable”.  Hindsight on this chart is easy but trading the hard right edge would not have been as smooth as “hypothetical”.

 

Using A Moving Average To Show Tough Conditions

I don’t use much in the way of trading indicators but an intermediate term moving average can give you an indication of trading conditions.

moving average
USDX WITH MOVING AVERAGE

This is a 20 period EMA and the green star indicates when EURUSD put in a double top – not long after the USDX double bottom.

Price begins to whip around the moving average which indicates that price is in relative balance at this point.  Markets that are in balance are tough to trade regardless of your trading experience.

While you can see the same thing with price action, using an indicator in this way allows you more objectivity and also helps you quickly scan charts worthy of your attention and risk.

If we take a look at the EURUSD with the 20 EMA applied, we see the same condition.

eurusd moving average
EURUSD WITH MOVING AVERAGE

Once price starts whipping around the moving average, much like the Dollar Index, stepping aside until the consolidation resolves is generally the better option.  You could trade the lower time frames but for longer term traders, that would be an entire shift in their business plan.

 

What The Dollar Index Is Showing

Looking at the USDX near the end of March, although we have seen some movement to the downside out of the smaller trading range, we still have lows less than $1 away.  Does the recent strong move in various currencies mean the consolidation is over?

No.

Although I’ve been long the EURUSD since early March, I need to see price acceptance during the smaller range breakout.  After that, 1.2550 zone is in the cross-hairs and you’d certainly want to see signs that buyers are back in control.

When markets are in consolidation, sudden momentum bursts are not uncommon and often times price will simply fall back into the trading range.  We can never know with 100% certainty what the markets will do.

We can plan for different outcomes and react when price reaches zones that may be considered a tipping point – such as the high or low of a trading range

Combining the resolution of the EURUSD, GBPUSD, and USDJPY with the resolution of the Dollar Index gives you a double whammy approach to trading the top 3 crosses.

 

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CoachShane

Trader at Netpicks
Shane his trading journey in 2005, became a Netpicks customer in 2008 needing structure in his trading approach. His focus is on the technical side of trading filtering in a macro overview and credits a handful of traders that have heavily influenced his relaxed approach to trading. Shane started day trading Forex but has since transitioned to a swing/position focus in most markets including commodities and futures. This has allowed less time in front of the computer without an adverse affect on returns.

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