Make Your Own Index
Make Your Own Index
Hello traders! In every Forex class I teach at Online Trading Academy, we discuss certain "odds enhancers" that can help us in our trading. These odds enhancers on a chart include trendline or moving average intersections with supply and demand levels, divergences from price with indicators/oscillators, candlestick patterns, etc., etc. Another set of odds enhancers include watching oil, gold, copper, interest rates and perhaps the dollar index. This week we will discuss the dollar index and my own views of it.
First of all, the dollar index is a weighted index of the strength of the US dollar vs. several other currencies. These other currencies and their approximate weights are the EUR 58%, JPY 13%, GBP 12%, CAD 9%, SEK 4.2% and CHF 3.5%. Why is the EUR weighted so heavily? Because it actually consists of over a dozen countries and their own economies, each with their own strengths and weaknesses. Similar to the S&P 500 index, when the Dollar Index is trending up, the strength of the dollar is increasing vs. this basket of currencies, and when trending down, the dollar is weakening vs. this basket of currencies. My "problem" with the dollar index and using it to help me trade is the weight of the EUR. Because the EUR is so heavily weighted, the dollar could be weakening against all the other currencies, yet if it is strengthening vs. the EUR, the dollar index could still be going up! This may lead a new trader to doubt what could be a great short trade on the USDCHF. (A short trade on the USDCHF means the dollar is getting weaker while the CHF is getting stronger.)
If you choose to use the dollar index as one of your odds enhancers, be aware of this weighting. It can definitely help when trading the EURUSD pair as the two charts should have an inverse correlation, but when trading the USDCHF, I personally don't look at the dollar index at all. Here is a chart showing this correlation on weekly charts from last summer:
Figure 1
Notice how when the dollar index chart is trending lower, the EURUSD is trending higher, and when the dollar index is trending higher, the EURUSD is trending lower. Using this correlation on the time frames, your trade can help as an odds enhancer. Notice the difference of the dollar index vs. the USDCHF. While there is some correlation, it is not nearly as obvious as the EURUSD pair. This is why I don't use the dollar index in my own trading.
What happens if you want to trade the GBP, but want to look at the Pound Index? Well, you have to make your own index by looking at several charts. It is easier than you think! In the following set of charts, we have the GBPUSD, GBPCAD and the EURGBP. In these charts, the trendlines are drawn merely for direction, not as an example of how to draw tradable trendlines! In the first two pairs, the GBP is on the left side of the pair, which is showing GBP weakness on the chart. The third chart has the GBP on the right side, which is showing the GBP getting weaker vs. the EUR. In our imaginary GBP index, what direction would it be going? If you answered down, you would be correct! So how does this help us trade? The idea is this: When making up your own index, you should be looking for trades in the directions (strength or weakness of the individual currency) that your index tells you. Generally speaking, if a currency is getting weaker vs. two or three major currencies, it is probably getting weaker vs. all of them. Looking for trades in the general direction of this imaginary index will help you be right more often - an odds enhancer! One extra hint on this technique. Make sure you are looking at the same time frame you trade. If you are a short-term intra-day trader, comparing monthly charts will do you no favors! If you watch a 4 hour, 1 hour, and 15 minute chart, I would try this technique on the 4 hour or 1 hour charts to see if it helps your win/loss ratio.
Figure 2
While the whole idea of making your own index for the different currencies may seem complicated at first, I believe it can definitely help your trading!
Until next time, Rick Wright
About Rick Wright
Rick studied economics and psychology at Iowa State University, and entered into the brokerage business in 1992. He earned the NASD Series 4,7,9,10,24,55,63, and 65 licenses. He helped grow an online brokerage business which was eventually sold off. Rick has also held positions as broker, branch manager, and several VP positions in the brokerage business.Rick began trading equities in 1997, and was introduced to the Forex market in 2002. Currently trading from home in Dallas, Rick is also a frequent contributor to various TV and business talk radio shows.Rick's goal in class is to accelerate your learning curve of trading, instead of figuring things out with your own money. He will show you several examples of trading mistakes that he and others have made, which cost thousands of dollars in the past so you won't make the same mistakes.You will learn how to recognize the differences between long and short term trends, where to enter trades, and where to exit based on previous price action.
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