Foreign exchange trading involves buying and selling currencies with the intent of making a profit. However, forex trading is very challenging and tricky as a number of factors affect the exchange rates. While trading in currencies, it is important for traders to be fully aware of their positions, and whether they are making profits or losses.
While trading in forex, the traders have to maintain a margin account with the brokers. These margin accounts allow the traders to take a short-term loan from the brokers, and leverage their positions.
Before you can place a trade, you are required to deposit an initial margin. Based on the amount of margin money you have, your maximum position size will be decided. As an example, a transaction to buy USD 100,000 may require a margin of 2%. This means that if you have $2,000 as margin money, you can take a position upto $100,000.
As the exchange rates fluctuate, your positions will be mark-to-market in real time, i.e., they will reflect the current market value of the positions. As the positions are marked-to-market, your margin balance will also change. There are two key concepts here: unrealized P&L and realized P&L. When a position is marked to market, the position is still open, however, the position may currently be in profit or in loss. This is unrealized P&L. Once the trader closes his open position, the profit or loss will be booked, and is called realized P&L.
The profit or loss calculation is quite straightforward. It is simply the size of the position multiplied by the change in exchange rate (pip movement). Let’s take an example to understand this.
Assume that you have a 1,000 EUR/USD position. The current EUR/USD exchange rate is 1.2920.
Let’s say that the Euro strengthens and the EUR/USD rate on the next day is 1.2980. This is a movement of 60 pips, which translates into $6 (1,000 *60/10000).
Depending on whether we are long or short a currency, we will determine if this is a profit or a loss. In a long position, a price up is a profit, and vice-verse. In a short position, a price up will be a loss. We have a long EUR/USD position, and the price has moved up, so $6 is a profit. If the price had moved down by 60 pips, then it would be a loss.
One confusing aspect is why the profit/loss was in USD and not EUR. This is because of how our currencies are quoted. Our currency pair was EUR/USD, i.e. no. of dollars for one euro. So, when the price changes, it will be in terms of the no. of dollars.
Also note that a standard lot size is 100,000 and one pip is $10. So, once we know the price movement in pips, and the no. of lots, then P&L can be easily calculated. If a trader has purchased 5 lots, and the price change is 10 pips, then the P&L will move by 10*10*5 = $500.
In practice, you will never have to calculate your P&L, as this is automatically calculated in your brokerage account, and you can anytime check your marked-to-market margin account balance. If you are continuously making losses, your margin balance will erode and you may get a margin call from your broker to deposit more margin money.