What is Forex Trading: Meaning and How It Works

We often talk about Forex market, financial markets and online trading, but what exactly is Forex? In this article we try to clarify its meaning and how Forex works today, especially with the arrival of innovative financial instruments such as CFDs

What is Forex Trading? This is an acronym and stands for Foreign exchange market, which can be translated as "exchange of foreign currency". This is the currency market, since each currency is a financial asset that can be exchanged for other currencies or for other goods. In Forex, currencies are exchanged for other currencies at variable and not fixed rates.

After its definition, to understand exactly what Forex is, it is advisable to explain its history. The currency market has not always been as we know it today, i.e. at variable rates that depend on the market law of supply and demand.

History

Forex was in fact born in 1971 when US President Nixon put an end to the Bretton Woods agreements. These agreements had been stipulated in 1944 to avoid major speculation on currencies, especially on those of defeated countries or which have suffered heavy losses and destruction.

The Bretton Woods agreements created fixed exchange rates with the US dollar, which had an additional fixed rate with gold. Precisely 1 ounce of gold had a value of 35 dollars.

These agreements lasted until August 1971, when Nixon decided to suspend the convertibility of the dollar into gold, as US gold reserves were running low. It was in fact in the period of the Vietnam War and a drastic increase in public spending. At the end of the year the members of the G10 decided to follow the American policy, we are talking about Germany, Belgium, Canada, the United States, France, Italy, Japan, the Netherlands, the United Kingdom and Sweden.

From that moment on, the value of currencies was therefore no longer linked to the dollar (which was linked to gold), but from the supply and demand of the market, variable exchange rates were born, Forex trading was born.

Forex is today the most liquid market in the world, every day it is estimated that 4,000 billion dollars are traded on the currency market. Forex is an international and deregulated market, in fact free trade is in force. Having clearer ideas about what Forex is, we can now explain how it works and we will do it in the next paragraph.

How it works

Unlike many other financial assets, Forex currencies are always traded in pairs. If you buy one currency, you must necessarily give another currency in exchange. For this reason we talk about currency pairs or currency crosses.

To give a more specific example, let's take the euro-dollar exchange rate, expressed as EUR/USD. It indicates the negotiation between euros and dollars, in this case how many dollars it takes to buy 1 euro. The result is a real division.

The first currency (EUR) is in the numerator, the second (USD) is in the denominator, the result is the quotient. If the euro-dollar exchange rate is hypothetically at 1.16, it means that 1.16 dollars are needed to buy 1 euro. Obviously if we exchange the numerator and denominator (USD/EUR) the result will change and in the case just proposed it will be 0.86. So it will take €0.86 to buy 1 dollar.