The Dollar Index ($DXY) and EUR/USD Trade
Fellow Traders! Today I am going to discuss one of our favorite strategy i.e. the Short Credit Spread. Due to recent market conditions, we are going for a Short call spread in /6E options, the EUR/USD futures contract. My currency trade ideas are driven by understanding The Dollar Index ($DXY) and EUR/USD Trade, so here is a short summary followed by the actual trade.
Understanding the U.S. Dollar Index (DXY)
The U.S. Dollar Index (DXY) is a critical financial instrument that measures the value of the U.S. dollar relative to a basket of major foreign currencies. Since its inception in 1973, the DXY has been a benchmark for gauging the international strength of the U.S. dollar. This article delves into the composition, calculation, and significance of the DXY Index, and explores how it correlates with stocks, commodities, and other currencies followed by a real EUR/USD trade idea.
Composition of the DXY Index
The DXY Index comprises six major currencies weighted geometrically:
- Euro (EUR): 57.6%
- Japanese Yen (JPY): 13.6%
- British Pound Sterling (GBP): 11.9%
- Canadian Dollar (CAD): 9.1%
- Swedish Krona (SEK): 4.2%
- Swiss Franc (CHF): 3.6%
The euro holds the largest weight, making the DXY particularly sensitive to changes in the EUR/USD exchange rate.
Calculation Method
The DXY Index is calculated using a geometric weighted average of the exchange rates of the basket currencies against the U.S. dollar. The formula is:
Explanation of the Formula:
- Base Value (50.14348112): Ensures the index was 100.00 on its base date in March 1973.
- Exchange Rates: Each currency pair is raised to the power of its weight (positive for USD quoted currency pairs and negative for foreign currency quoted pairs).
Interpreting the DXY Index
- Increase in DXY: Indicates the U.S. dollar is strengthening against the basket of currencies.
- Decrease in DXY: Suggests the U.S. dollar is weakening relative to these currencies.
Correlation of DXY with Other Financial Instruments (last 20 years).
Once can see that it has a high negative correlation with the EUR at -0.93, which makes sense as dollar goes up, euro goes down and vice versa.
EUR/USD:
Strong Inverse Correlation with DXY: Since the euro constitutes 57.6% of the DXY, movements in EUR/USD significantly affect the index.
This is the last 1-year chart of /6E which is the EUR/USD futures contract. I believe this is trading at it highest after the fed’s recent 50 bps cut as the future expectation for USD is to be lower and conversely the EUR pair to be higher. Historically when the DXY index trades around100, the EUR trades between 1.08 and 1.09. Currently it is sitting at 1.1199.
The EUR/USD Trade
As a contraction, I am looking to be bearish in this pair through a Short Call Strategy. I was trying to get this trade filled on Friday 09/20/2024 but it didn’t come to my price so I will be selling a limit order at 1.15/1.16 short call spread again, 47 days out, collecting $125. We will be looking to close this trade for a 50-60% max profit i.e. when the P/L is around $70. We are only putting down $225 for this trade for a potential ROI of ~22%.
Here is the trade setup from my broker platform with over 80% chance of winning.
Send me any feedback / questions or suggestions, good bad or worse on info@thelongshortidea.com
If you want to learn more about how to exactly set this up on the platform, then manage the trade by converting it into an iron condor and then rolling it out in time, please join us in our next FREE Trading cohort on October 4th. Sign up on the link below.
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