US Dollar – The World’s Reserve Currency
If you are a currency trader, and focus on trading one or more of the major currency pairs—EUR/USD, GBP/USD, USD/CHF and USD/JPY—then consider yourself a specialist. Yes, it’s true! You are a specialist in the US Dollar—a “Greenback Guru” so to speak.
Each currency “pair” is obviously comprised of two currencies. If you you are long the GBP/USD, then you are actually buying pounds and selling dollars. If you are short the USD/JPY, then your are actually selling dollars and buying yen.
In each of the major currency pairs, the USD is a part of the equation. This means if you study and understand the fundamentals of the US Dollar, the US Economy and the inner workings of the Federal Reserve Bank of the United States, then you’ve done most of the work needed before you should consider trading any of the four major currency pairs!
The so-called majors are the most liquid and widely traded currency pairs in the world. Trades involving the majors make up about 90% of total Forex trading. Think about it…if the USD is half of every major currency pair, and the majors represent 90% of the entire market, then your focus on understanding what drives the USD will have a huge impact on nearly all of your future trade plans.
There is also a wonderful benefit of specializing in trading the USD. The United States, since roughly end of World War II, has been the Reserve Currency of the world. What does that mean? It means that the fate of the USD has a much larger impact on the Forex market than any other currency.
As of the start of 2006, according to the International Monetary Fund (IMF), the combined currency composition of the world’s identified official foreign exchange reserves was as follows:
| Currency | % of total |
| USD | 66.3% |
| EUR | 24.8% |
| GBP | 4.0% |
| JPY | 3.4% |
Source: Currency Composition of Official Foreign Exchange Reserves
What’s Your USD Bias?
The only thing you need to do is determine your bias—US Dollar likely to strengthen or to weakens—then apply this to the various world currency pairs. Notice what side of the equation the USD is in the currency pair. When you buy a currency pair, you are buying the first currency and selling the other. For example, if your bias is for the US Dollar to strengthen, then you would want to buy USD. Here’s a list of the kind of trade you would enter in each of the four major currency pairs:
| Pair | Buy or Sell |
| USD/CHF | Buy |
| USD/JPY | Buy |
| EUR/USD | Sell |
| GBP/USD | Sell |
In all cases, you are long the USD and short the other currency in the pair. One bias, four trades.
This is generally true, but each currency pair will reactive differently to the USD. That’s because each local currency pair has its own strengths and weaknesses…has its own value. For example, if the EUR is also strengthening it would move less with the USD strengthening than the JPY if the Yen was weakening. Generally speaking, however, the majors all move predictably in one direction or the other in relation to the strength or weakness of the USD.
How often is this true? Not 100% of the time, but most of the time.
The Currency Correlation Coefficient
You should always include an evaluation of the majors currency correlation in every trade plan that you create. The correlation between currency pairs can change at any time, even for pairs which are normally 95%+ correlated.
Correlation is determined by what is known as the correlation coefficient, which ranges between -1 and +1. The following table explains the meaning behind that number:
| Type of Correlation | Correlation Coefficient | Interpretation |
| Perfect positivecorrelation | +1 | As one pair moves, either up or down, the other pair will move in the samedirection |
| Perfect negativecorrelation | -1 | If one pair moves, either up or down, the other pair will move in the oppositedirection |
| Zero correlation | 0 | The two pairs move independently of one another; there is no relationship between movement of one pair and the other |
Using Currency Correlation to Your Advantage
Say, for example, that you’ve located some data on currency correlation coefficients based on the last 100 trading days, and determined the following:
· The GBP/USD moved the same as the EUR/USD 97% of the time
· The USD/CHF move the opposite direction of the EUR/USD 99% of the time
Armed with this kind of information, you can avoid entering two different positions that would likely cancel each other out. By knowing that EUR/USD and USD/CHF move in opposite directions roughly 99% of the time, you would conclude that having an open long trade in EUR/USD, while also being in a long USD/CHF trade, is the same as having virtually no position at all. The two trades would effectively cancel each other out, due to the negative correlation exhibited by these two pairs. In other words, when your long EUR/USD moves up in price, your USD/CHF long will be going down by nearly the same amount, resulting in a pretty pointless trade at double the spread cost. Instead, the savvy trader, understanding this negative correlation, would enter both a long EUR/USD position and a short USD/CHF position—basically, shorting the USD in two different trades.
More importantly, you can make trade entry and exit decisions based on currency correlation. Say, for example, theGBP/USD starts showing some volatility and approaches a resistance level. While you anticipate entering a long trade on a breakout, you notice that the other three major currency pairs are not moving in proportion to the pound’s move. In other words, the EUR/USD is not moving up, the USD/CHF is not moving down, and the USD/JPY is not moving down. This is a clue that the pound’s move might be driven by, say, news on the British economy, or a major corporate merger involving a UK-based company. Knowing that this move is pound-driven and not USD-driven, you can shift your focus to either (a) making aGBP/USD trade with reduced risk (involving fewer mini-lots), or (b) ignore the pound’s move, and wait for a later opportunity which involves simultaneous, correlated moves of all major pairs.
Consider another scenario: You’ve just entered a short EUR/USD trade, and you’re scanning for clues as to whether the pair will either proceed in the desired direction toward your profit target, or go against you and cause you to exit with a small loss. Your EUR/USD trade has broken the s1 support pivot level and appears headed for m1. However, the pound has just paused at its own s1 pivot level, and is showing signs of reversing to the upside. In this kind of situation, currency correlation might tell you that the pound needs to break through its s1 before the euro can reach m1. If the pound does break its s1 level, then you’re probably poised to exit your short euro trade at m1 with a profit. If the pound reverses and heads back to the upside, then you start watching the indicators which will tell you when to exit the trade (according to your trade plan) before incurring a significant loss.
Trading a Basket of Currencies
As you mature in your Forex training, you may eventually choose to diversify your risk by trading a so-called “basket” of all four majors based on one correlated, simultaneous movement of the USD. If you right, you’ll be very right. However, if your wrong, you’ll be very wrong. Therefore it is in your best interest to completely understand currency correlation before trading any live Forex account.
Correlation Coefficient Data
Correlations can, and do change over time. Regularly update the currency correlation coefficient data you use to make your trading decisions. You may wish to check these two links on a regular basis.
| This site provides historical correlation data for most major FOREX pairs for the previous 100 days | |
| Visit this site if you wish to see how the major USD-based currency pairs are correlated in the more recent timeframes of 5 to 50 days |
Remember: Stay aware of everything going on, and never take anything for granted in Forex.
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