Muebles

Students learn more by watching than they do by listening.

Robert Kiyosaki (1944-)

In the introduction to this forex trading book, I covered some of the cross market linkages and relationships that exist between the four major capital markets. But now it's time to start looking at some of the major indices which provide us with more detailed information about these, starting with the US Dollar Index, which follows neatly on from the previous chapter.

The USD Index is perhaps the most important index of all, since if you accept the premise that every market revolves around money, then the principle currency has to the the currency of first reserve, namely the US dollar. Indeed, it could be argued that to be truly successful as a forex trader, we really only need to have a view of the USD, as every other market, instrument and flow of money centres on this currency.

Nevertheless, in this chapter we are also going to focus on several other indices which, in a variety of ways, all give us a different perspective on risk, money flow, and market sentiment.

But let me begin with the USD Index.

The prime function of the Dollar Index is to reveal market sentiment towards the US dollar, crucial information to us as forex traders. And it is the one index which you should watch on an intra day basis, particularly if you are trading short time scales or scalping. The index should be on your screen at all times because it is so important.

By contrast you only need to watch some of the other indices detailed here on either a daily or weekly basis as they are designed to provide a longer term view.

The USD Index is so important because it reveals, on one easy to understand chart, market sentiment towards the US dollar with all the ramifications of risk and sentiment across bonds, commodities, equities as well as currencies directly.

Put simply, if the USD Index is falling, then currencies quoted against the dollar are likely to be rising and visa versa, although as you will discover later in the book, some currency pairs are not that straightforward.

The Dollar Index was created in 1973 following the move to free floating exchange rates and the collapse of the gold standard.

As the name suggests it is an index of the US dollar measured against a basket of six major currencies, which all carry varying degrees of weight, according to their importance. The only change to the constituents of this basket of currencies came when the Euro was launched and

the Euro has the largest percentage at 57.6%.

The other five currencies which make up the index are: the Japanese yen with 13.6%, the

British Pound with 11.9%, the Canadian Dollar with 9.1%, the Swedish Krona with 4.2%, and finally the Swiss Franc with 3.6%.

When the index was initially established in 1973 it began with a notional value of 100, and since then we have seen the index move to highs in the 160 region, indicating a strong dollar, to lows in the 70 region, indicating a very weak US dollar.

The Dollar Index is available in several different forms, either as a futures contract, with both the CME and ICE exchanges who offer a dollar index futures contract, or more commonly as the spot market index. If you have a futures brokerage account and futures feed, the ticker symbol for the ICE is DX, and for the CME, a joint venture with the Dow Jones Index, is FX$INDEX.

If you are simply trading in the spot FX markets, then there are two great places to find a chart.

The first is an excellent site with live prices on this, and indeed many other indices and futures, at http://www.investing.com - this used to be Forexpros and is one of the best free resource sites on the web. The other site is another favourite of mine at

http://www.netdania.com – again free, and furthermore you will also find charts for many other markets covered here as well.

Any chart of the Dollar Index, is just like any other, and we use exactly the same techniques of technical analysis, to forecast market direction, and consequent strength or weakness in the US dollar.

As I said earlier this is the primary index that all forex traders should have on their screen at all times, regardless of the currency pair or time frame traded.

Fig 10.10 USD Index Chart

Fig 10.10 is a typical chart for the USD index and, as you can see, it looks much the same as any other candlestick price chart. I do cover candlesticks as well as other technical indicators later in the book. Interpreting strength and weakness using the chart is identical to any other chart. We consider price patterns, candle patterns, support and resistance, trends and price breakouts.

So, are these the indices that I use in my own analysis of strength or weakness in the US dollar? And the answer is a categoric, NO.

Why?

Well in simple terms, I do not believe that the above indices, provide a balanced and realistic picture of the US dollar against the other major currencies. One only has to look at the

construction of the basket of currencies for the index created in 1973. Here we now have the euro at just under 58% and with the UK pound, the two currencies constitute almost 70% of the weighting. Wholly unbalanced in my view, and the Australian dollar doesn’t even feature! So in my humble opinion, far from representative of today’s forex market. For me, there are far better choices which are simple to understand, and more importantly provide a realistic view of the US dollar against the major currencies.

The index I use is new, and indeed was only launched in 2011 following a collaborative agreement between FXCM and S&P Dow Jones Indices. The ticker symbol is ^USDOLLAR and you can find this free on Yahoo finance. The reason I like this index is two fold.

First, the index is simple to understand, and second I believe it is far more representative in it’s construction. The index is quoted in terms of four base currencies, the four most liquid, namely the euro, the Japanese yen, the British pound and the Australian Dollar. The four currencies then each has an equal weighting at 25%, far more realistic in my view, with the

‘European’ percentage diminished, the yen weighting almost doubled, and the significance of the Australian dollar recognised. These four currencies between them account for over 80% of forex volumes daily, so to me it just makes sense.

When it was launched in 2011, the base for the index was an equivalent $10,000 long position against these four currencies, which is why the index is quoted in terms of 10,000 as the unit of measurement. So in terms of interpreting any index moves, it is very straightforward, as a 100 pip move against the underlying currencies, will then translate into a 100 point move on the index. This is one of the many reasons I now use this index exclusively. It’s simple to

understand, simple to interpret and provides a far more balanced and realistic view of the market in terms of US dollar strength and weakness.

Finally, there is also one other reason, and that’s the fact that the dollar index has a sister index for the Japanese yen! This has the ticker symbol ^DJFXJPY and once again is constructed in much the same way as the dollar index. The currencies in this case are the US dollar, the Australian dollar, the euro and the New Zealand dollar, and the index was launched in 2012.

With these indices, you now have two of the most important currencies in the forex world, quoted in a clear, simple and realistic way, and which reflects the significance of the principle currencies in the market today.

In the two charts below, you can see both these indices, the first is the US dollar index in Fig 10.11, and the second is the Japanese yen index in Fig 10.12. These are from my own

NinajTrader platform, driven from the Kinetick data feed and using the tickers USDOLLAR.X and DJFXJPY.X respectively. Naturally the choice of US dollar index is yours, and indeed there are others available, and I’m sure some of you reading this may have your own

favourites. These are the ones that I like, and as I said in the foreward to the book, KISS works for me every time!

Fig 10.11 FXCM Dollar Index

Fig 10.12 FXCM Yen Index

VIX

Second in importance to the Dollar Index is the VIX and the reasons are that this an indicator which can tell us so much about market sentiment and money flow. The VIX is often referred to as the investor fear gauge, as it reveals market sentiment and risk appetite in the equity

markets.

One question often asked by forex traders is why should we be concerned with an index which deals with equities? However, I hope the chapter on the links between equities and currencies will have given you the answer.

The VIX was originally introduced in 1993 by the CBOE ( Chicago Board Options Exchange), and was named the Volatility Index, but is always shortened to the VIX. Generally this has a ticker symbol of either ^VIX or $VIX or similar, and can be a little more tricky to find.

Here are a couple of places where you can find the chart for free, albeit on a delayed feed. The alternative is to have this delivered as part of your futures feed from your broker. However, both of the following sites will give you an adequate chart for a long term perspective, but for short term intra day trading, a live feed is essential.

Fig 10.13 is a chart of the VIX, taken from my NinjaTrader platform and once again using the Kinetick data feed.

Fig 10.13 VIX 30 Minute Chart

As with the Dollar Index that we looked at earlier, the chart is the same as for any other price chart.

The VIX can be found at Yahoo finance www.finance.yahoo.com and here the ticker symbol is

^VIX, and also at www.barchart.com.

But what is this index telling us, and why is it so important?

The VIX has become the benchmark for stock market volatility and, as a result, an indicator of investor fear. Volatility generally goes hand in hand with turmoil, as panic spreads amongst investors who look for safe havens once panic selling takes hold.

If the stock market is the heart, then the VIX is the pulse, as it provides a measure of the mood of traders and investors using options prices from the S&P 500 companies - not all of them, but a representative sample of these large blue chip companies.

The index is constructed based on implied volatility, a term from the options market, but which essentially looks out to the next 30 days and tries to forecast the likely volatility of the S&P

500 index.

In many ways it’s not necessary to know how the index is constructed, we just have to know how we use it.

In the options market there are two instruments. Put options and call options. A put option INCREASES in value if the underlying asset FALLS, whilst a call option INCREASES in value if the underlying asset rises. As a result, if there is more put option buying, then this is a signal to us, as speculators, that investors are fearful and buying these options as protection against a falling market.

As a consequence the VIX will therefore rise.

However, if more call options are being bought then this is a signal that investors are

complacent and willing to take on more risk, so the VIX will fall. And this is the reason why the VIX is known as a contrarian indicator.

When the VIX is at a very low level this means that investors are buying equities and taking on more risk, and the further the index falls then the more likely equities will reverse from an upwards trend to a downwards trend. In other words, from a bullish market to a bearish market.

Conversely, as equities tumble the VIX will move sharply higher as panic takes hold and, once at an extreme, it is at this point that equities are likely to reverse once more and move from bearish to bullish.

The chart itself will typically have a scale from zero to 100, although these extremes have rarely, if ever been reached. However, there are some key numbers which will give us signals as to a likely change of direction for the equity markets, which in turn tell us about risk, money flow and market sentiment.

If we start with the VIX at a low level, if the index moves anywhere close to, or into, the 10 -12 range, or even into single figures, then investors and the market are very complacent, and happy to continue buying risk assets.

At these levels in the index, we are likely to see a change in trend in equities in due course, with the bullish trend coming to an end and transitioning to a bearish trend, with a consequent flow of money out of high risk markets and into lower risk asset classes.

At the other end of the scale, the key levels are when the VIX moves above 30 and into the 40 plus price area. In this region, investors will be starting to panic as equity markets begin to fall. Anywhere beyond 50, then everyone is selling but at this point we also start to look for a major reversal and for the bearish trend to end and the start of a new bull trend. This is why it is called a contrarian indicator.

When everyone is selling, we are looking for the markets to turn higher, and when everyone is

buying we are looking for the markets to turn lower.

To put this into context for you, since the VIX was introduced, the highest reading it has ever recorded was in 2008 during the dark days of the financial crisis when markets went into free fall and the index touched 89.53. However, the average trading range is between 50 and 10 and a lowest reading of 9.39 posted in 2006.

The VIX is all about risk, fear and market sentiment, and as such, reveals what investors are thinking as well as telling us where the money flow is likely to move in the future.

Along with the US dollar index the VIX is an extremely important index to watch all the time and, one which also has a strong relationship with the Dollar Yen currency pair for reasons I will explain later in the book.

The VIX can be analysed in two ways. First, we look to see the level of where we are on the index itself, which tells us whether we are close to a major turning point, simply by whether the VIX is low or high. And the way to remember this is with a simple rhyme which is as follows:

When the VIX is low it's time to go - in other words sell.

When the VIX is high it’s time to buy - in other words the bear market is over and likely to reverse soon.

Easy to remember.

The second way to analyse the VIX is to treat it just like any other chart. We analyse the candles in exactly the same way, except with this chart we are also looking at the level of the VIX itself. So we have two analytical approaches with this index which help to reinforce one another.

For example, if we see a strong reversal candle signal which is coupled with the VIX at a significant low or high point, then this reinforces our analysis of a potential turning point in the equity market. Therefore, we can expect a consequent change in market sentiment and risk.

This is the power of the VIX and is yet another of the premier indices that you need to watch closely in order to trade in the forex markets successfully

The time frame you choose will, of course, reflect your trading strategy, and this applies to all the major market internals. If your approach to the forex markets is as an intra day trader or scalper, perhaps only holding positions for a few minutes at a time, then a live feed for these indices is essential.

Having watched many professional traders from the futures markets, this is perhaps one of the major differences between retail traders and full time traders.

A scalping trader on tick charts or fast time based charts, will almost certainly have the tick or

time equivalent charts for the VIX and the US Index, since the moves in both will reflect the constant ebb and flow of sentiment and money, throughout the trading session.

Imagine this like the swell of a big sea, constantly moving, constantly changing. And if there is a strong reversal pattern or signal on the price chart for the USD index, and the VIX, then both are confirming a change in market sentiment. This change may only be for a few minutes, or perhaps for a few hours, but it will give you the confidence to take the trade in your chosen currency pair, provided this reinforces your analysis.

What we are actually doing is very simple – we are quantifying risk by analysing associated market price action – in this case in market internal indices, but the principle is the same. We can then reinforce the analysis by considering the price action in multiple time frames. Another key approach and one which I will cover in more detail later in this book.

Using multiple time frame analysis to assess the risk of the trade makes trading less stressful and increases the probability of success. For example, if the VIX appears to be moving higher in the 1 min chart but is still bearish in the 5 and 15 minutes, then the risk assessment is simple.

The move in the 1 min may only be a short term pull back and any trade taken will be short and be against the dominant trend.

This principle applies to all charts, whether on the instrument itself, or an associated index. It is an immensely powerful technique, and when coupled with the knowledge of relational analysis, becomes yet another weapon in the arsenal of the forex trader.