Profit and loss (P&L) is how
traders measure success and failure. You don’t want to be looking at the forex
market as some academic or thrill-seeking exercise. Real money is made and lost
every minute of every day. If you’re going to trade currencies actively, you
need to get up close and personal with P&L.

A clear understanding of how
P&L works is especially critical to online margin trading, where your
P&L directly affects the amount of margin you have to work with. Changes in
your margin balance will determine how much you can trade and for how long you
can trade if prices move against you.

### Margin Balances and Liquidations

When you open an online currency
trading account, you’ll need to pony up cash as collateral to support the
margin requirements established by your broker. That initial margin deposit
becomes your opening

**margin balance**and is the basis on which all your subsequent trades are collateralized. Unlike futures markets or margin-based equity trading, online forex brokerages do not issue**margin calls**(requests for more collateral to support open positions). Instead, they establish ratios of margin balances to open positions that must be maintained at all times.
If your account’s margin balance
falls below the required ratio, even for just a few seconds, your broker
probably has the right to close out your positions without any notice to you. In
most cases, that only happens when an account has losing positions. If your
broker liquidates your positions that usually mean your losses are locked in
and your margin balance just got smaller.

Be sure you completely understand
your broker’s margin requirements and liquidation policies. Requirements may
differ depending on account size and whether you’re trading standard lot sizes
(1 00,000 currency units) or mini lot sizes (10,000 currency units). Some brokers’
liquidation policies allow for all positions to be liquidated if you fall below
margin requirements. Others close out the biggest losing positions or portions of
losing positions until the required ratio is satisfied again. You can find the
details in the fine print of the account opening contract that you sign. Always
read the fine print to be sure you understand your broker’s margin and trading
policies.

### Unrealized and realized profit and loss

Most online forex brokers provide
real-time mark-to-market calculations showing your margin balance.

**Mark-to-marker is the calculation that shows your unrealized P&L based on where you could close your open positions in the market at that instant**. Depending on your broker’s trading platform, if you’re long, the calculation will typically be based on where you could sell at that moment. If you’re short, the price used will be where you can buy at that moment. Your margin balance is the sum of your initial margin deposit, your unrealized P&L, and your realized P&L.
Realized P&L is what you get
when you close out a trade position, or a portion of a trade position. If you
close out the full position and go flat, whatever you made or lost leaves the
unrealized P&L calculation and goes into your margin balance. If you only
close a portion of your open positions, only that part of the trade’s P&L
is realized and goes into the margin balance. Your unrealized P&L will
continue to fluctuate based on the remaining open positions and so will your
total margin balance.

If you’ve got a winning position
open, your unrealized P&L will be positive and your margin balance will
increase. If the market is moving against your positions, your unrealized
P&L will be negative and your margin balance will be reduced. FX prices are
constantly changing, so your mark-to-market unrealized P&L and total margin
balance will also be constantly changing.

### Calculating profit and loss with pips

Profit-and-loss calculations are
pretty straightforward in terms of math - it’s all based on position size and
the number of pips you make or lose. A

**pip is the smallest increment of price fluctuation in currency prices**. Pips can also be referred to as**points**, we use the two terms interchangeably.
I’m not sure where the term pip
came from. Some say it's an abbreviation for percentage in point, but it could
also be the FX answer to bond traders’ bips, which refers to bps, or basis
points (meaning 1/100 or 1 percent).

Even the venerable pip is in the
process of being updated as electronic trading continues to advance. Just a
couple paragraphs earlier, i tell you that the pip is the smallest increment of
currency price fluctuations. Not so fast. The online market is rapidly
advancing to decimalizing pips (trading in 1/10 pips) and half-pip
prices have been the norm in certain currency pairs in the interbank market for
many years.

But for now, to get a handle on
P&L calculations you’re better off sticking with pips. Let’s look at a few
currency pairs to get an idea of what a pip is. Most currency pairs are quoted
using ﬁve digits. The placement of the decimal point depends on whether it’s a
JPY currency pair - if it is, there are two digits behind the decimal point.
For all others currency pairs, there are four digits behind the decimal point.
In all cases, that last itty-bitty digit is the pip.

Here are some major currency
pairs and crosses, with the pip underlined:

**EUR/USD**: 1.285

__3__

**USD/CHF**: 1.226

__7__

**USD/JPY**: 117.2

__3__

**GBP/USD**: 1.928

__5__

**EUR/JPY**: 150.6

__5__

Focus on the EUR/USD price first.
Looking at EUR/USD, if the price moves from 1.2853 to 1.2873, it‘s just gone up
by 20 pips. If it goes from 1.2853 down to 1.2792, it’s just gone down by 61
pips. Pips provide an easy way to calculate the P&L. To turn that pip
movement into a P&L calculation, all you need to know is the size of the
position. For a 100,000 EUR/USD position, the 20-pip move equates to $200 (EUR
100,000 x 0.0020 = $200). For a 50,000 EUR/USD position, the 61-point move
translates into $305 (EUR 50,000 x 0.0061 = $305).

Whether the amounts are positive
or negative depends on whether you were long or short for each move. If you
were short for the move higher, that’s a - in front of the $200, if you were
long, it’s a +. EUR/USD is easy to calculate, especially for USD-based traders,
because the P&L accrues in dollars.

If you take USD/CHF, you’ve got
another calculation to make before you can make sense of it. That’s because the
P&L. is going to be denominated in Swiss francs (CHF) because CHF is the
counter currency. If USD/CHF drops from 1.2267 to 1.2233 and you’re short USD
100,000 for the move lower, you’ve just caught a 34-pip decline. That‘s a
profit worth CHF 340 (USD 100,000 x 0.0034 = CHF 340). Yeah but how much is that in real money? To
convert it into USD, you need to divide the CHF 340 by the USD/CHF rate. Use
the closing rate of the trade (1.2233), because that’s where the market was
last, and you get USD 277.94.

### Factoring profit and loss into margin calculations

The good news is that online FX
trading platforms calculate the P&L for you automatically, both unrealized
while the trade is open and realized when the trade is closed. So why did I
just drag- you through the math of calculating P&L using pips? Because
online brokerages will only start calculating your P&L for you after you
enter a trade.

To structure your trade and manage
your risk effectively (How big a position and how much margin to risk?), you're
going to need to calculate your P&L outcomes before you enter the trade.
Understanding the P&L implications of a trade strategy you’re considering
is critical to maintaining your margin balance and staying in control of your
trading. This simple exercise can help prevent you from costly mistakes, like putting
on a trade that’s too large, or putting stop-loss orders beyond prices where
your account falls below the margin requirement. At the minimum, you need to
calculate the price point at which your position will be liquidated when your
margin balance falls below the required ratio.

ReplyDeleteeTorois the #1 forex broker for beginner and advanced traders.