Currency trading offers a challenging and profitable opportunity for well-educated investors. However, it is also a risky market, and traders must always remain alert to their trade positions. The success or failure of a trader is measured in terms of the profits and losses (P&L) on his or her trades. It is important for traders to have a clear understanding of their P&L, because it directly affects the margin balance they have in their trading account. If prices move against you, your margin balance reduces, and you will have less money available for trading.

SEE: Forex Tutorial: Introduction To Currency Trading

Realized and Unrealized Profit and Loss
All your foreign exchange trades will be marked to market in real-time. The mark-to-market calculation shows the unrealized P&L in your trades. The term "unrealized," here, means that the trades are still open and can be closed by you any time. The mark-to-market value is the value at which you can close your trade at that moment. If you have a long position, the mark-to-market calculation typically is the price at which you can sell. In case of a short position, it is the price at which you can buy to close the position.

Until a position is closed, the P&L will remain unrealized. The profit or loss is realized (realized P&L) when you close out a trade position. When you close a position, the profit or loss is realized. In case of a profit, the margin balance is increased, and in case of a loss, it is decreased.

The total margin balance in your account will always be equal to the sum of initial margin deposit, realized P&L and unrealized P&L. Since the unrealized P&L is marked to market, it keeps fluctuating, as the prices of your trades change constantly. Due to this, the margin balance also keeps changing constantly.

Calculating Profit and Loss
The actual calculation of profit and loss in a position is quite straightforward. To calculate the P&L of a position, what you need is the position size and by how many pips the price has moved. The actual profit or loss will be equal to the position size multiplied by the pip movement.

SEE: 6 Factors That Influence Exchange Rates

Let's look at an example:

Assume that you have a 100,000 GBP/USD position currently trading at 1.6240. If the prices move from GBP/USD 1.6240 to 1.6255, then the prices have move up by 15 pips. For a 100,000 GBP/USD position, the 15 pips movement equates to USD 150 (100,000 x 15).

To determine if it's a profit or loss, we need to know whether we were long or short for each trade.

Long position: In case of a long position, if the prices move up, it will be a profit, and if the prices move down it will be a loss. In our earlier example, if the position is long GBP/USD, then it would be a USD 150 profit. Alternatively, if the prices had moved down from GBP/USD 1.6240 to 1.6220, then it will be a USD 200 loss (100,000 x -0.0020).

Short position: In case of a short position, if the prices move up, it will be a loss, and if the prices move down it will be a profit. In the same example, if we had a short GBP/USD position and the prices moved up by 15 pips, it would be a loss of USD 150. If the prices moved down by 20 pips, it would be a USD 200 profit.

The following table summarizes the calculation of P&L:

100,000 GBP/USD Long position Short position
Prices up 15 pips Profit $150 Loss $150
Prices down 20 pips Loss $200 Profit $200

Another aspect of the P&L is the currency in which it is denominated. In our example the P&L was denominated in dollars. However, this may not always be the case.

In our example, the GBP/USD is quoted in terms of the number of USD per GBP. GBP is the base currency and USD is the quote currency. At a rate of GBP/USD 1.6240, it costs USD 1.6240 to buy one GBP. So, if the price fluctuates, it will be a change in the dollar value. For a standard lot, each pip will be worth USD 10, and the profit and loss will be in USD. As a general rule, the P&L will be denominated in the quote currency, so if it's not in USD, you will have to convert it into USD for margin calculations.

Consider you have a 100,000 short position on USD/CHF. In this case your P&L will be denominated in Swiss francs. The current rate is roughly 0.9129. For a standard lot, each pip will be worth CHF 10. If the price has moved down by 10 pips to 0.9119, it will be a profit of CHF 100. To convert this P&L into USD, you will have to divide the P&L by the USD/CHF rate, i.e., CHF 100 / 0.9119, which will be USD 109.6611.

Once we have the P&L values, these can easily be used to calculate the margin balance available in the trading account. Margin calculations are typically in USD.

You will not have to perform these calculations manually because all brokerage accounts automatically calculate the P&L for all your trades. However, it is important that you understand these calculations as you will have to calculate your P&L and margin requirements while structuring your trade even before you actually enter the trade. Depending on how much leverage your trading account offers, you can calculate the margin required to hold a position. For example, if your have a leverage of 100:1, you will require a margin of $1,000 to open a standard lot position of 100,000 USD/CHF.

The Bottom Line
Having a clear understanding of how much money is at stake in each trade will help you manage your risk effectively.

SEE: Getting Started In Foreign Exchange Futures

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