How the Dollar Index Works

Trading Strategy
This is a guest post by Luke Arthur

When trading in the foreign exchange market, the value of the dollar has an impact on much of what goes on. The value of the dollar is influenced by many factors such as the gross domestic product, interest rates and other economic data. To determine the value of the dollar in relation to the other major currencies of the world, analysts and investors use a tool known as the U.S. Dollar Index. The dollar index is a numerical comparison to a basket of six of the major currencies that are represented in the world markets.

Currencies Compared

The United States Dollar Index compares the dollar against six of the most influential currencies in the world. The basket of six currencies is composed of the Japanese Yen, the Euro, the Canadian Dollar, the Great Britain Pound, the Swedish Krona and the Swiss Franc.

To compare the value of the dollar to these six currencies, they are not compared on a currency to currency basis. Instead, the basket is weighted, depending on the size of the economy that they represent.

In the basket of currencies, the Euro has the biggest position as it represents 21 countries in Europe. It makes up more than 55 percent of the weighted average. The Japanese Yen makes up the next largest part of the basket at around 13 percent. Next in line is the Great Britain Pound, followed by the Canadian dollar, the Krona and then the Franc.

Why It’s Important

The U.S. Dollar Index plays a vital role in the Forex market and determining the value of the dollar. Since the majority of the major economies of the world are represented in this index, it is a solid indicator of the strength of the dollar against other currencies. When the dollar index moves, it can impact foreign exchange quotes and reflects changes in the values of all the currencies involved.

Dollar Index Represented

Many Forex traders like to keep up with the dollar index by reading a chart in much the same way as other currency pairs are tracked. The U.S. Dollar Index is compared to a relative value of 100. The dollar index was originally started in 1973 when the gold standard was officially removed and major currencies were allowed to float relative to one another. If the dollar value index is less than 100, it means that the dollar has lost value since it originally started. If it is more than 100, it means the dollar has gained value on the other currencies.

Using the Dollar Index

While the dollar index is not the only thing to look at while Forex Trading, it is definitely something to pay attention to. This index can give you an idea of what the dollar is doing in relation to other currencies and it can help you make decisions when trading. Used in conjunction with other indicators and tools, it can help you be more successful in the Forex market overall.

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