Friday, 31 January 2014

Profit and Loss

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: 1.2853
USD/CHF: 1.2267
USD/JPY:  117.23
GBP/USD: 1.9285
EUR/JPY:  150.65

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. 


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