Guest contribution provided by Forex Traders
As the global economy continues to emerge from the worldwide economic debacle of the last two years, investors have increasingly turned to risky assets in 2011. One could well argue that 2008, 2009, and 2010 were three of the most volatile years in the history of financial markets. In the forex market, we saw the most commonly traded currency pair, the EUR USD, make 3,000 pip swings on 3 separate occasions!
As we head into the summer months, traders and analysts are continuing to weigh the probability of a continued strong global recovery in order to develop a plan of action for the rest of the year. Two of the most commonly used tools for determining the risk bias of investors at large are the VIX and the U.S. dollar index.
Risk On, Risk Off
Financial markets tend to be driven by one of three behaviors—risk appetite, risk aversion, and indecision. During times of risk appetite, investors will shift capital into higher yielding assets such as equities, exotic currencies, and emerging markets. During times of risk aversion, investors will shift capital into very safe, conservative investments which offer very low yield, such as the U.S. dollar and Japanese yen. During times of indecision, the market will generally move sideways as investors await the next wave of financial data in order to determine whether risk aversion or risk appetite will take over.
The U.S. Dollar Index
When the Federal Reserve announced it would move forward with Quantitative Easing Round 2 in November 2010, it basically sealed the fate of the U.S. dollar over the next year. As other central banks such as the European Central Bank and Bank of England move into rate tightening cycles, the U.S. dollar is set to continue to be driven lower as the yield differential between it and other developed nation currency widens, with the exception of the Japanese yen.
This interest rate environment at the Fed has caused investors to have no interest in the U.S. dollar as the global recovery continues to expand. Investors are shifting their capital out of U.S. dollars and into higher yielding assets in search of growth. However, when risk aversion sweeps the market, or fear, then the U.S. dollar does tend to still strengthen as investors still find U.S. government debt to be the safest investment in currency trading.
Pairing the U.S. dollar index and the VIX together is powerful because the VIX measures the level of volatility in the market—specifically implied volatility in SPX options. It is sometimes called the “Fear Index” because it tends to spike up when fear and uncertainty abound. Now, if the VIX is showing a high level of volatility and fear, which direction do you think the U.S dollar index will go? Of course, it will most likely be headed up. Conversely if the VIX is relatively low, showing strong confidence in the market, then the U.S. dollar index will most likely be falling. This analysis can be a powerful tool in forex trading in determining general sentiment and bias on popular U.S. dollar pairs such as EUR USD and GBP USD.
How To Practically Use These Tools
As a forex trader, the U.S. dollar index is a powerful tool that can help identify potential reversal points. A very practical strategy is to pull up both any dollar-based currency pair and the U.S. dollar index charts at the same time. Let’s assume you love to trade EUR USD. Let’s also assume that EUR USD is moving up and you want to buy a dip.
After you conduct some technical analysis, you identify a potential area of strong support at 1.4500 in the chart above. This area is the 38% Fibonacci retracement, a key area of former support/resistance, and a key round figure. Now, pull up the U.S. dollar index.
As EUR USD is rising aggressively, the U.S. dollar index is falling since the dollar is weak. If EUR USD begins to correct to the downside to your 1.4500 buy area, you want to see if the dollar index is going to hit resistance at the same time EUR USD hits support. In the chart above, you can see strong resistance just above 74.60, which is the 50% Fibonacci retracement and strong previous support. If the EUR USD and U.S. dollar index both hit these spots at close to the same time, and the VIX is at a low value, then the strategy suggests that a quality setup is occurring to buy EUR USD and/or sell U.S. dollar index.
The U.S. dollar index and the VIX can provide traders with powerful tools to confirm potential reversals and price exhaustion in the forex market.
Disclaimer: Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite.