From the November 01, 2010 issue of Futures Magazine • Subscribe!

Building a better U.S. dollar index

Trader considerations

Other benefits of the index include less sensitivity to volatility, short-term trading benefits, and cleaner technical analysis and systematic model signals.

Most traders can appreciate how an index compared to individual currencies can offer a healthy dose of protection against volatility and uneven reaction to events. In "Jobs shock" (below), you can see the forex reaction to the number one economic indicator in the United States: the non-farm payrolls.

chart

This particular report was weak, so the foreign currencies futures rallied sharply. The five-minute chart displays both the Dow Jones CME FX$INDEX and the Australian dollar. Notice that just before the release of the data, the index rallied but the Aussie sank. Then the Aussie struggled to catch up with the rally of the majors, peaked prematurely and belatedly caught up with the up move of the index. In the second half of the chart, the Aussie tumbled while the index suffered only a mild pullback. The index provided a safer way to express demand for foreign currencies in response to a negative factor for the U.S. dollar. While this example is based on the calculated index and not actual prices, the simple construction of the index will make it easy for arbitrageurs to help keep it in line with its theoretical values.

Forces affecting the U.S. dollar have a way of overwhelming individual currencies. When you trade on the dollar fundamentals, you are forced to select which pair would best react to those fundamentals or trade the established dollar index. This steadiness also makes it easier to hold on to longer-term positions compared to individual currency pairs. While we all strive to identify trends, once we find them, we tend to fight them all the way to the end. It may be counterintuitive, but it’s not always easy to deal with the volatility. In "Steady mover" (below), you can see the inverse of the Dow Jones CME FX$INDEX and the dollar/yen. Notice the clear uptrend and then the shorter term downtrend in the index compared to the choppy moves in the dollar/yen, which made it quite difficult to hold long-term positions.

chart

The trading strategies discussed here are theoretical as the Dow Jones CME FX index has not reached a critical mass in term of liquidity, but while most new futures contracts fail, those that succeed often have related markets for liquidity providers to lean on. That is the case here and if liquidity can build, currency traders will have a valuable tool in their tool box to managed risk.

Cornelius Luca is president of LGR (www.LucaFXTA.com). He is author of "Trading in the Global Currency Markets," Prentice Hall Press, 3rd edition 2007; "Technical Analysis Applications in the Global Currency Markets," Prentice Hall, 2nd edition 2000; "Technical Analysis Applications," McGraw-Hill, 2004; "Introduction to Technical Analysis," Euromoney Institute, 1997.

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