Forex trading is a thrilling experience that requires a strong heart and mind to win. If you are planning to trade forex, you must have a thorough understanding of the market and your positions at all times because the bottom line of each trade is the P&L you make from it. So, let’s understand how this calculation works in forex!
Understanding the Basics of Profit and Loss in Forex Trading
In order to understand the basics of profit and loss, it’s crucial to be aware of two important aspects in currency trading: Pips and Position size.
Pips are minuscule fluctuations in exchange rates. They are so small that they are generally priced to four decimal places, with a single pip measuring a 1/100th of 1% movement. The exception is currency pairs containing the Japanese yen, where pips are measured to only two decimal places. If this sounds confusing to you, then you can use a pip calculator to find out the exact values of pips in the currency of your choice.
On the other hand, Position size refers to the total units of the currency being traded. Here’s an interesting fact! You don’t necessarily need to deposit a huge amount to open a big position. Forex brokers offer leverage, which is a kind of loan that allows traders to multiply their position. This means traders can put up only a fraction of the required capital and still trade a larger position size which is bigger than their actual capital. Since higher leverage means higher profits and losses, traders must get their position size right.
Now to understand how pips and position link to each other and how they impact PnL, you should know that most brokers offer standard, micro and mini lots for position sizing.
If the quote currency in the trading pair is the same as the account currency, then a standard lot (100,000 units) is worth 10.00 USD per pip, a micro lot is worth 0.10 USD per pip movement, while a mini lot (10,000 units) is worth 1.00 USD per pip. However, if the account currency is not the same as the base currency of the currency pair being trade, you must effectively switch the account currency to the base currency of the pair you wish to trade to calculate the pip value.
Now you know that the pip value depends on a number of factors, including position size. Profit and loss in trade are determine by the number of pips a currency moves in favour or against the trade’s speculation. The profit and loss in a big position size will also be bigger. Moreover, it is important to note that profits or losses remain unrealised until a position is close. When you close out a trade, you realise the profits or losses.
How to Calculate Profit and Loss in Forex Trading?
Let’s go deeper into the nitty-gritty of profit and loss calculation in forex trading. The fundamental Pnl calculation involves multiplying the position size (number of units traded) with pip movement. While it is more convenient to use a Forex calculator, it is crucial to comprehend the mechanics behind the calculation.
To illustrate, let’s take the example of EUR/USD, so if you currently hold a position of 100,000 EUR/USD, which is trading at 1.4145, then if the prices surge from 1.4145 to 1.4155, that translates to a 10-pip movement. Therefore, for a 100,000 EUR/USD position, the 10-pip hike amounts to a sweet $100 (100,000 x .0010).
Here’s the crux: if you have a long position and the prices go up, it’s a profit, and if they go down, it’s a loss. Conversely, if you have a short position, a price rise translates to a loss, and a price dip is a profit.
There is also another important aspect, that is, the currency in which the account is denominated.
For instance, let’s take the EUR/USD pair. Suppose the pair experiences a bullish trend, and the exchange rate increases from $1.2180 to $1.2220, representing a 40-pip gain. If you had entered a long position with a standard lot size of 100,000 units, your profit would be 328.80 EUR (40 pips x 8.22 EUR). Another way to calculate this would be to multiply the pip value (8.22 EUR) by the price movement (40 pips), resulting in a profit of 328.80 EUR.
However, if you had entered a short position with a standard lot size of 100,000 units and the EUR/USD pair experienced a bearish trend, dropping by 80 pips from $1.2220 to $1.2140, you would have suffered a loss of 657.60 EUR (80 pips x 8.22 EUR).
Suppose you had a mini account with an account currency denominated in euro, and you had entered a long position on the EUR/USD pair with 2 mini lots (20,000 units) at an exchange rate of $1.2210. If the pair rallied by 30 pips to $1.2240, your profit would be 49.32 EUR ( 30 pips x 3.27 EUR [pip value for 1 mini lot] ). On the other hand, if the pair dipped by 50 pips to $1.2160, you would have incurred a loss of 81.80 EUR (50 pips x 3.27 EUR)
Impact of Currency Exchange Rates on Profit and Loss Calculation
Since the purpose of forex trading is to make a profit from the difference in exchange rates, it’s evident that the impact of exchange rates on profit and loss calculation is significant. For instance, in a long position, when the exchange rate of a base currency in a pair increases, it results in a profit for the trader. On the other hand, if a trader has taken a short position in this scenario, it would mean a loss to the trader. Conversely, if the value of a base currency depreciates against the quoted currency, traders with a long position will incur a loss, while those with a short position will incur a profit.
Common Mistakes in Profit and Loss Calculation and How to Avoid Them
- One common mistake is not understanding the difference between realised and unrealised profit/loss. Unrealised profit/loss refers to the potential profit or loss on an open position, whereas realised profit/loss is the actual profit or loss realised when the position is close. Only the realised profit or loss determines your true success or failure in the market. So don’t make the mistake of counting your chickens before they’re hatched – wait until you’ve close out your positions before celebrating your victories or mourning your losses.
- Another common mistake is not factoring in swap rates and commissions when calculating profit and loss. You can avoid this by taking into account all the factors that may affect the Pnl in a trade. You can use other trading tools to calculate swap rates, commissions and more parameters to be sure about the profits or losses you would make.
- Not accurately calculating pip values and position sizes can also lead to calculation errors. Therefore, you can either use a pip value calculator or, if you are manually calculating pip values and position sizes, ensure that you are doing it correctly.
Profit of loss is a yardstick of success or failure in trading. Therefore you should watch the market’s fluctuations and adjust your trades accordingly to maximise the profits and minimise the loss.