Trading the Dollar – U.S. Dollar Index, Currency Pairs, Dollar ETFs



Bullish or bearish on the U.S. dollar? Well, these three investments can help you take advantage of the dollar’s next move.

1. U.S. Dollar Index

One of the most widely watched and traded benchmarks of U.S. dollar strength/weakness is the U.S. Dollar Index.

This index tracks the value of the U.S. dollar against a basket of six major currencies — the euro, Japanese yen, Canadian dollar, British pound, Swedish krona and Swiss franc.

The index was created in 1973, with a base value of $100. So the U.S. Dollar Index having a current value of 76 tells us that dollar has declined 24% against the basket of currencies in the U.S. Dollar Index.

Futures traders use the index as a way to either get long or short the dollar. Because it is priced against a basket of currencies instead of just one currency, it’s a more diversified way of playing movements in the U.S. dollar.

Here’s how that works:

When traders short the U.S. Dollar Index, they are in effect selling U.S. dollars and going long the six currencies in the index. When traders buy the U.S. Dollar Index, they are effectively shorting the six currencies in the index and buying the U.S. dollar.

2. Currency Pairs

Traders who are looking for a more targeted way to trade the dollar will trade “currency pairs.”

A currency pair gives you the ability to go long or short the dollar against a specific currency — i.e., short the dollar, long the euro … or long the dollar, short the Japanese yen, etc.

Pairs trading is important because not all currencies will decline or appreciate against the dollar evenly. Over a six-month period, the euro might increase in value by 15% over the dollar, while the yen may only appreciate 7% over the dollar during the same time period.

Currency pairs give traders more flexibility in honing in on those currency relationships that they feel have the most upside. Remember, all currency trading is relative. The whole game comes down to betting that one currency will go down (or up) relative to another currency.

In other words, you can trade any pairing that you choose, in which you’re betting that one will go up while the other will drop. That’s the “exchange” in “foreign exchange” (or forex).

For example, the USD/CAD currency pair enables you to go long the U.S. dollar while simultaneously shorting the Canadian dollar against it. This pairing is otherwise known as the “Dollar-Canada” or, less formally, the “loonie.”

There are many other pairings with the dollar and others that do not involve the dollar (those are called cross-currency pairs).

3. Dollar ETFs

While more and more individuals are learning how to trade currencies, many individual investors still find this type of trading (i.e., futures trading) to be very intimidating. The good news is that there are now many currency exchange-traded funds (ETFs) available.

These ETFs mimic the underlying currency or currency index without the risk normally associated with direct futures trading.

PowerShares has two ETFs based on the dollar. One allows you to profit if you believe the U.S. Dollar Index will rise, and the other allows you to profit if you feel the U.S. Dollar Index is going to go down.

The PowerShares DB US Dollar Index Bullish Fund (UUP) and the PowerShares DB US Dollar Index Bearish Fund (UDN) were created to mimic the underlying index.

However, as a note of caution, due to transaction costs and price differences between contract rolls, currency ETFs will typically underperform the index that they are tracking. From what I’ve seen, though, this underperformance isn’t as egregious as we’ve seen in the oil ETFs, but it is present and you should be aware of it.

Investing Tools for Currency Traders

So there you have it — you can bet on the direction of the dollar with currency pairs, the Dollar Index, and two currency ETFs based on the Dollar Index.

Even though currency trades are often very short term in nature, as an investor you may find it easier to join the forex trading game with instruments (i.e., indexes and ETFs) that are more familiar and readily accessible.

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