What is Forex Trading and how does it work?

The Forex industry keeps on rapidly expanding, making Forex even more popular than before, especially among developing countries like the Philippines. Filipinos in particular, has quickly become one of the fastest-growing Forex trading communities. As brokers have seen the opportunity that there is a surge in Filipino traders joining the trading industry.

The Forex Market is now seeing everyday gains as more traders discover the benefits and potential of trading Forex.

So what Is “Forex”?

“Forex” is the abbreviation most used today for “foreign exchange,” meaning the price of one currency in terms of another currency. All Forex prices, by definition, refer to the connection between two currencies, or a pair of currencies.

The term “Forex” is used interchangeably with the term “FX.” Both are used today and both refer to the same thing, foreign exchange. The term “FX” is mostly used in the US while “Forex” was more broadly used in the UK until recently. Professional traders at banks and brokers in the United States tend to use the term "FX," but "Forex" is the term used in the retail sector, which has been adopted from British usage. The term "currency" is also used, as in "I trade currencies" or "something happened in the currency market."

Foreign exchange refers literally to money, or more accurately, to money in two different denominations. The “exchange” part of the term means giving one thing of monetary value in return for a different thing of equivalent value. The word exchange refers to the transaction in which each of two parties is willing to exchange his respective basket of money for the equivalent amount of money denominated in the second currency. The exchange rate is the price at which the two parties are willing to make the trade.

The price of one currency in terms of another currency is called a “rate” and not a “price,” although the word “price” is equally valid and often used. Foreign exchange is the only market in which the word rate is used in place of the word price. The reason for this usage is probably due to the word “rate” being used since the Middle Ages to refer to a tariff or tax levy, since converting one currency to another entails applying a ratio or a proportion to one currency relative to the other. A common Latin phrase is “pro rata” from “pro rata parte,” meaning “in proportion.” The English term "rate" comes from the Latin "rata."

What Is Being Exchanged in the Forex Market?

A foreign exchange transaction can be as easy as buying a basket of 165 dollars in exchange for £100 at an airport kiosk since foreign exchange refers to two baskets of money, each with its own currency. The exchange rate is $1.65 per UK pound sterling.

Why is the exchange rate not £0.6061 per dollar? This the same exchange rate, just expressed differently (it is the reciprocal, or 1 divided by 1.65). The answer lies in the historical convention of quoting the price of other currencies in terms of what they cost in pounds. The pound sterling was the benchmark currency for centuries until just after World War II, meaning the central currency against which all other currencies were judged and priced.

Following WWII, the US dollar became the reference currency, and most other currencies were valued in terms of how many units of the foreign currency could be obtained for one dollar.

Following WWII, the US dollar became the reference currency, and most other currencies were valued in terms of how many units of the foreign currency could be obtained for one dollar.

As a rule, any money not issued by your home government is “foreign.” The natural way to look at foreign exchange is to ask: “How many units of the foreign currency can I get for a fixed amount of my home currency?” This is how a tourist or an importer looks at foreign exchange. However, because the dollar is now the benchmark currency against which almost all other currencies are exchanged, the dollar appears first in the names of many, but not all, currency pairs. In most currency pairs, the first name is the most important, while the second is secondary or less important.

Putting a name first is to assume that the fixed amount is denominated in that currency and the variable amount will be the other currency. In other words, the first currency is the base and you are applying a ratio to derive the price of second currency. When the European Monetary Union decided to quote the euro in the format “Euro/USD” and “Euro/JPY,” etc. it was a deliberate choice to make the euro the more important of the two currencies in every pair.

the European Monetary Union decided to quote the euro in the format “Euro/USD”

The rule is that whichever name comes first is the one that is getting stronger on higher numbers and weaker on lower numbers. If the number goes up in the pound, for example, from 1.6000 to 1.6500, it means the pound is getting stronger and by definition, the dollar is getting weaker because in this pair, the full quote should read GBP/USD. It is accurate to express the quote as $1.6000 to $1.6500, meaning the pound used to cost $1.6000 but now it costs $1.6500. Journalists usually apply the convention of putting the dollar sign in front of the price quote, although brokers and analysts tend not to insert the currency symbol.

This is also true of the euro (EUR/USD) so a higher number always means the euro is getting stronger vis-à-vis the dollar. You could say the EUR/USD moved from 1.3200 to 1.3900, meaning it got more expensive in dollar terms. If you're new to Forex, you can get your bearings by putting an imaginary currency symbol in front of the first-named currency. Therefore, the price quote now looks like $1.3200 to $1.3900.

The pound, euro, Australian dollar, and New Zealand dollar are the top key currencies in which the dollar does not come first, because of historic convention. All other currencies are quoted in terms of dollars, such as USD/CHF = US dollar against the Swiss franc.

Below is the Yahoo! Finance’s list of major currencies. Yahoo! Finance is one of many providers of market information in the professional and retail Forex market. Other providers, including brokers, have their own version of this list.

Yahoo! Finance is one of many providers of market information in the professional and retail Forex market.

What do we mean about Cross-rates?

A cross-rate used to be any currency pair that didn't include your home currency. For someone in the UK or Europe, the US dollar/Japanese yen exchange rate would be a cross-rate.

Today, however, the common definition of a cross-rate is any currency pair that does not include the dollar. Therefore, the USD/JPY exchange rate is a “major” exchange rate and not seen as a cross-rate by people in the UK or Europe, while the AUD/CAD would be seen as a cross-rate by everyone, including Australians and Canadians, even though the rate includes their home currencies.

This convention for defining a cross-rate is not accepted everywhere and you will see lists in newspapers and websites that define cross-rates differently. The US dollar accounts for about 70% of global government money reserves and 70% of world trade, so placing the dollar as a component in all the major exchange rates is not without justification. In fact, there are more dollars in banknotes and bank deposit accounts outside the United States than there are inside the United States, so it's possible that the dollar is the most widely used currency in some places despite not being the local currency. When someone says "the euro," however, he is always referring to EUR/USD and never EUR/GBP, in which case the second currency must be mentioned.

See the list of Yahoo! Finance's European cross-rates. This is a typical list for European countries:


Evolving Practices

Yahoo!, one of the top news and data providers, chooses to include non-dollar crosses as “major world currencies.” As a practical matter, if you are trading euro/dollar, you can say “euro” without the word “dollar” and you will be understood. If what you really mean is “euro/yen”, though, you must say the name of the second currency.

What to do when Exchanging with real currencies?

When you go to the airport kiosk to exchange your home currency for another one, you are not trading. You are a price-taker. The kiosk sign tells you what exchange rate will be applied and you are stuck with it. You can take it or leave it.

This is not trading. Trading is the practice of negotiating with the opposing party until you find the price that makes both of you the least dissatisfied. Trading entails negotiating a price that is acceptable to both parties and may involve game-playing, deception, and other techniques. You may be bidding on something the other person thinks is more valuable than you do, or you may be offering something you value more highly than other people out there who want to buy. When the final price is agreed upon by both parties, the outcome is a contract, whether by handshake or formal papers, that you will bring your basket of currency to the other party and he will bring his basket of currency to you at some stated location and time. In fact, the actual exchange is usually a wire transfer from one checking account to another in each of the two countries of issuance.