Currency Indices

A forex index give an objective view of a currency’s international value by comparing it to several of its peers. Because the index is formed of multiple currencies, a significant rise or fall in one currency is balanced out by the remaining constituents. This guide to trading currency indices explains how they work, including their benefits and limitations. We also list the best brokers for trading forex indices.

What Is A Currency Index?

A currency index is a way to measure the performance of a single currency by comparing it to a basket of similar currencies. For example, the British Pound Index assesses the strength of the GBP against the currencies of its key trading partners, including the Euro, US Dollar, Japanese Yen, and Swiss Franc.

By measuring a base currency against several others, the forex index gives a more holistic view of its performance than you would get from a single currency pair as extremes are balanced out.

This makes currency indices a useful way to gauge a country’s overall economic performance; when an index rises, the country is usually performing strongly and vice versa.

Generally, only major currencies have forex indices that can be easily traded. The most common currency indices you can find for online trading are the US Dollar, Pound Sterling, Euro, and Japanese Yen.

The most popular way for retail investors to trade forex indices is through CFDs, allowing users to go long or short with leverage.

How Do Currency Indices Work?

Currency indices can be calculated in various ways, but the most common approach is to measure them against the currencies of a country’s main trading partners, weighted according to each partner’s proportion of the country’s total trade volume.

The Bank of England uses this kind of trade-weighted index for the UK currency. The British Pound Index includes all trading partners whose share of UK exports or imports for the last three years are on average above 1%.

The US is the single largest country on the index with a weighting of around 20%, followed by China with a weighting of around 12%. But the UK’s largest trading partner is the EU, and the Euro is weighted at around 42%.

Importantly, forex index brokers often use their own formulae. As a result, the exact currencies and weightings may differ somewhat between trading platforms. For example, the weighting for the GBP Index at CMC Markets can be seen below.

CMC Markets – GBP Index Weighting

Benefits Of Trading Currency Indices

• Gives an overall view of a currency’s performance, including the GBP, USD and EUR
• Balances out extreme price movements that can arise when trading currency pairs
• Opportunity to go long or short with derivatives like CFDs
• Can be used for hedging and portfolio diversification
• Trading available 24/5

Risks Of Trading Currency Indices

• Complex products with many factors that influence each currency’s value, making it hard to predict future trends
• Vulnerable to unforeseen events that can badly affect a country’s economy
• Some traders prefer the higher volatility found in trading currency pairs
• Best time to trade different forex indices varies

How To Trade Forex Indices

The most popular investment vehicles available to UK traders are:

• CFDs – A contract for difference, or ‘CFD’, is a derivative where the trader’s profit or loss equals the difference in the underlying asset’s price at contract open and at contract close. Open a long position on a CFD if you believe the forex index’s value will rise or a short position if you think it will fall. CFDs can also be traded with leverage; for example, Pepperstone offers forex index trading with leverage up to 1:5.
• Futures – A future is a derivative contract in which the counterparties agree to complete a trade for an underlying asset at an agreed price at a predetermined time in the future. The profit or loss from this trade is determined by the difference between the agreed price and the market value of the asset when the contract expires.
• Options – An options contract gives investors the right but no obligation to complete a trade on an underlying asset at an agreed time in the future. The key difference between this and a futures contract is that you don’t need to complete the trade, meaning that if the trade goes against you, your losses will be limited to the premium paid for the options contract.
• ETFs – You can also trade currency indices as part of an ETF (exchange-traded fund), for example, the Invesco DB US Dollar Index Bullish Fund. ETFs can be used as a hedging tool.

Comparing Brokers With Forex Indices

• Fees – Most fees usually come from bid-ask spreads and/or commissions. For CMC Markets, the spreads on currency indices vary depending on the currency you choose; the USD index is the tightest with spreads from 0.25 pts whereas the JPY index has spreads from 5 pts. You also need to account for any swaps fees for positions held overnight, deposit and withdrawal charges and inactivity costs.
• Index List – Before registration, check which currency indices are available with a broker and the instruments you can use to trade them. Pepperstone, for example, offers CFD trading on three different currency indices.
• Trading Platform – The trading platform is the application used for everything from technical and fundamental analysis to executing trades. FXTM is one of several leading forex index trading brokers that support multiple high-quality platforms, including MetaTrader 4 and MetaTrader 5. Some brands will also offer their own proprietary platforms.
• Regulation – Brokers with currency indices that are licensed by the UK’s Financial Conduct Authority or other reputable regulators must adhere to rules that protect clients. Negative balance protection is one example of this that stops clients from becoming indebted to their brokers due to a bad trade.
• Support Desk – The best forex index brokers make it easy to seek help by offering contact methods such as live chat on the website or by calling up a phone hotline. Pepperstone, for example, is contactable 24 hours a day, Monday to Friday.
• Demo Account – Several brokers such as CMC Markets offer free demo accounts. These are excellent ways to test out forex index trading strategies under real market conditions or to build up experience with a new platform.

Trading Strategy

Popular approaches to trading currency indices include:

• Technical Analysis – This involves the use of indicators and charting tools on a platform. Useful indicators for trading forex indices include the relative strength index, stochastic oscillator and moving averages. Technical analysis involves predicting upcoming price-action and opening positions by analysing past market movements. This is most often used in short-term trading strategies such as trend-following or trend reversals.
• Fundamental Analysis – This relies on news and knowledge of economic indicators for a currency’s intrinsic value. You can analyse a country’s economy to support predictions for future price action. News to be aware of includes economic projections and announcements such as inflation and central bank rates hikes, political events such as changes in government and natural disasters and crises. An economic calendar with key dates can help you can stay informed of upcoming events.

Trading Hours

The trading hours for each index will depend on the broker and currency index. For example, the US Dollar Index CFD at CMC Markets can be traded between midnight and 10pm (GMT) Monday to Friday.

However, futures on the US Dollar Index via the Intercontinental Exchange (ICE) are available from 6pm on a Sunday until 10pm the following Thursday with breaks between 10pm and 1am every day.

Bottom Line On Forex Index Trading

Through currency indices, investors have a different way of trading the forex market by evaluating the overall strength of a currency. The best forex index brokers offer several leading currencies, including the British Pound Index and the US Dollar Index.

FAQs

What Is An Index In Forex Trading?

A currency index is a group of forex pairs that measure the strength of a single base currency. For example, the Bank of England’s Pound Sterling Index weighs GBP against the currencies of the UK’s largest trading partners, including the US, Europe, and China.

What Is The Difference Between Trading Forex And Forex Indices?

Forex trading involves making investments in single pairs, such as EUR/USD or GBP/USD. Forex index trading involves a single currency’s performance, which is measured by weighing it against several relevant currencies at once. Importantly, forex pairs are more volatile.

Is Trading Currency Indices Better Than Forex Pairs?

Currency pairs and indices are similar in many ways, though pairs tend to be more volatile. A forex index will give a more objective and stable view of a currency’s overall performance, but you are likely to find more products and brokers to invest in popular currency pairs.

How Do You Use The US Dollar Index To Trade Forex?

The US Dollar Index is a useful measure of the overall strength of the USD. It can be used as a helpful indicator of how the currency compares on the world stage against other major currencies such as the Euro and Chinese Yuan. It can also serve as the basis for derivative products such as CFDs.

Article Sources

CMC Markets Currency Indices

FXTM Currency Indices