Profit and Loss Calculation
Up to the present we have thoroughly learnt the basic terms and notions applied at Forex, and also principal of margin trading. It is the time to study how to calculate profits and losses of the executed deals.
We know that Internet trader enters the international currency market with the help of dealing company which opens an account for trader in the US dollars. To be able to work on Forex trader should transfer initial amount of money to that account. All profits and losses regardless the currency of a deal, are converted into the US dollars. In this chapter we will consider in details the principal of profit and loss estimation.
In general case the formula for computation of the financial result after you made a deal looks as follows:
Financial result = (buy price – sell price) * number of lots * lot size – commission * number of lots ± bank interest
Obviously the financial result consists of three parts: trading result, paid commissions and bank interest.
We know that there are two types of quotations on Forex (not taking into account cross rates) – direct and indirect quotes. In the first case, the base currency of quotation is a foreign currency in relation to the US Dollar and it is expressed (quoted) in the US dollars. In the second case, the US dollar is a base currency of quotation itself and it is denominated in the foreign currency unit. The trading result in the given above formula is calculated in the quoted currency. Commissions and bank interest are usually denominated in the US dollars, so the formula is true only for the direct quotes. It should be mentioned that in this formula buy and sell prices are not components of the quotation but real price which we bought or sold currency at, regardless which operation was before (buy or sell). If the financial result is positive, we get profit. If it is negative, we lose.
For indirect quote the difference between buy and sell price is expressed in the foreign currency, while total financial result is in US dollars. So to compute the financial result on the indirect quotes we should use the following formula:
Financial result = (1/buy price – 1/sell price) * lots number * lot size – commissions * lots number ± bank interest
The lot size depends on certain quotation (on currency pairs) and on the preferences of certain Internet broker. Presented above formulas are used, if the lot size is denominated in foreign currency (not US dollars). For instance, the lot size in the direct quotation GBP/USD can be 70 000 pounds sterling. Or lot size in the indirect quote USD/JPY can be 12 500 000 Japanese yen. If your Internet broker designates the lot size in the US dollars, then you will have to convert US dollars in the appropriate currency. The lot size denominated in foreign currency in such cases will not be fixed but will depend on the current rate relevant at the moment of position opening. In the US dollars the size of standard lot is usually equal to 100 000.
Estimation of the financial result on cross rates occurs in another way. As we learnt from the previous chapter, cross rates – rates of currencies against each other excluding the US dollar. Any cross rate can be presented by two US dollar quotations. For instance, cross rate EUR/JPY can be calculated by the quotes EUR/USD and USD/JPY. Computation of profit and loss occurs in the following manner. Firstly, it is estimated the financial result by the quotation EUR/USD, then financial result by USD/JPY. These results are summed up for getting total financial result.
As we all know, currency rates change by points. In different quotes the point size is various. Opening a deal, one has to know what result will be when the price changes by 1 point in the US dollar equivalent. It will help to assess your current profits or losses and close position in time. You can easily do it using the formulas given above and the value will depend on the type of quotation (direct or indirect), lot size, currency which lot is denominated in and a point value.
Let’s consider direct quote GBP/USD with 1 lot size in the amount of 70 000 pounds sterling and 1 point value 0.0001. As the quotation is direct, we use the first formula for calculation of the trading result. Minimal difference between buy and sell price is always 1 point, and in this case it is 0.0001. Thus, the trading result of currency pair GBP/USD rate change in 1 lot by 1 point is 0.0001 * 70 000 = 7 US dollars.
Let’s inspect the indirect quotation USD/JPY with the lot size 12 500 000 yen and point size 0.01. Because a quote is indirect, we use the second formula to assess the trading result. It is insufficient to know only a pip value in case of indirect quotation, because the trading result depends also on buy and sell prices. Suppose that the current rate is 104.75 Japanese yen for one US dollar. Thus, the trading result of the price change in volume of 1 lot by 1 point is ((1/104.75 – 1/104.76) * 12 500 000 = 11.39 US dollars. Worth mentioning that when buy and sell prices are different then the trading result is also different. If lot size was denominated in US dollars, then we would have to convert it to Japanese yen by the current price at the moment of position opening. And if one opens long position (purchase of dollars for yen), the calculations would be carried out by sell price, and if it is short position (selling dollar for yen), then it would be buy price.
As we can observe, the price change of different currency pair by one point leads to various trading result. In quotation GBP/USD it is less than in USD/JPY. The less trading result of rate changing by one point, the less loss you would suffer in case of unfavorable price movement. But on the other hand, you would have less profit if you catch Lady Luck. Beginning traders are recommended to work with less “aggressive” quotations such as GBP/USD and USD/CHF.
At the first glance, calculations presented at this chapter may seem too complicated. But you do not have to worry about because all estimations of profits and losses are made by the platform automatically. Different dealing companies use different trading platforms, but the principal of calculation remains the same. It is important to know what your profits and losses compounds of in order not to close a deal with losses by mistake!