What is the Dollar Index?

If you've traded stocks, you're probably familiar with all the indices available such as the Dow Jones Industrial Average (DJIA), NASDAQ Composite Index, Russell 2000, S&P 500, Wilshire 5000, and the Nimbus 2001. Oh wait, that last one is actually Harry Potter's broomstick.

Well if U.S. stocks have an index, the U.S. dollar can't be outdone. For currency traders, we have the U.S. Dollar Index (USDX).

The U.S. Dollar Index consists of a geometric weighted average of a basket of foreign currencies against the dollar.

Say whutttt!?! Okay before you fall asleep after that super geeky definition, let's break it down.

It's very similar to how the stock indices work in that it provides a general indication of the value of a basket of securities. Of course, the "securities" we're talking about here are other major world currencies.

The Basket

The U.S. Dollar Index consists of six foreign currencies. They are the:

• Euro (EUR)
• Yen (JPY)
• Pound (GBP)
• Canadian dollar (CAD)
• Krona (SEK)
• Franc (CHF)

Here's a trick question. If the index is made up of 6 currencies, how many countries are included?

If you answered "6", you're wrong.

If you answered "22", you're a genius!

There are 22 countries total, because there are 17 members of the European Union that have adopted the euro as their sole currency, plus the other five countries (Japan, Great Britain, Canada, Sweden, and Switzerland) and their accompanying currencies.

It's obvious that 22 countries make up a small portion of the world but many other currencies follow the U.S. Dollar index very closely. This makes the USDX a pretty good tool for measuring the U.S. dollar's global strength.

USDX Components

Now that we know what the basket of currencies is composed of, let's get back to that "geometric weighted average" part. Because not every country is the same size, it's only fair that each is given appropriate weights when calculating the U.S. dollar index. Check out the current weights:

With its 17 countries, euros make up a big chunk of the U.S. Dollar Index. The next highest is the Japanese yen, which would make sense since Japan has one of the biggest economy in the world. The other four make up less than 30 percent of the USDX.

Here's something interesting: When the euro falls, which way does the U.S Dollar Index move?

The euro makes up such a huge portion of the U.S. Dollar Index, we might as well call this index the "Anti-Euro Index". Because the USDX is so heavily influenced by the euro, people have looked for a more "balanced" dollar index. More on that later though. First, let's go to the charts!

1. What is the Dollar Index?
2. How to Read the Dollar Index
3. Trade-Weighted Dollar Index
4. Using the USDX for Forex
5. The Dollar Smile Theory

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