Teeka Tiwari

Don't End Up a Day Late and a Dollar Short

    Tweet This

Free Trading Guides

Shorting the U.S. dollar has been a great play since stocks bottomed in March. And the U.S. dollar looks to go lower in the longer term if we do not get our deficit spending under control.

However, over the short term, the dollar is very sensitive to movements in the stock market. As we've seen recently, even relatively mild pullbacks in the major indexes will almost certainly lead to rallies in the U.S. dollar as hot money looks for a safe and secure place to park itself.

3 Ways to Play 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.