In this lesson, we will talk about what we traders or investors concern the most-Forex Profit. Of course, everyone that enters an investment market expect to profit. No one buy an investment security in order to lose money. However, the cruel reality of the market is that someone is gaining money because another person is losing money.
For those who are new to the Forex market, knowing the fundamental philosophy and calculation of Forex trading profit is crucial.
Long and Short
The basic philosophy of profiting in any kind of security market is almost always to “buy low, sell high”. The Forex market is no different than other markets in this sense. Referring different status of buying and selling, people in the financial market uses the long position and the short position to express them.
Long Position
In Forex market, if you have bought a currency pair, you have entered into a long position. You bought because you believe that you were “buying low”, so you would be waiting for opportunity to “sell high”. And when that happens, you close the long position you were in.
Short Position
If Long is “buying low and selling high”, then Short is “selling high and buying low”. What is the difference between these two?
It is the timing and order of buying and selling.
A short is selling before buying.
Yes, you can sell before you buy. You can sell without owning the stuff you just sold. In the financial market, it is common for people to short a security, they just borrow the security and s
ell it. Of course, if there is a demand, there will always be people willing to do it with a fee.
In Forex, a short to is to sell a currency pair (sell base currency and buy counter currency). And you wait for the price to go low enough so that you can buy back the pair. (i.e. selling high and buying low.) At that time you have closed your short position.
Square
Being Square or flat is when you have no position in the market. In this state, you have no risk because you are not holding a security or owing one. In a long, you can go flat buying selling what you bought. In a short, you can buy what you sold to square up.
Profit and Loss
Everyone who trades currency online trades with a margin account. A margin account requires you to deposit a sum of cash (deposit) so that you can control a bigger sum of money (margin deposit).
For example, if the leverage ratio is 100:1, then you can control a sum of $100,000 by depositing $1,000 as the margin deposit. So that you will be trading with the amount of $100,000!
What does this have to do with your Forex profit and loss? The brokers use a way to calculate your profit or loss and if your margin balance falls below a certain level, your broker has the right to close your positions without even noticing you!
The calculation of your margin balance = initial margin deposit + unrealized profit and loss + realized profit and loss
We will talk about realized and unrealized profit and loss in the next session.
The level of margin balance you have to maintain to prevent this from happening is usually denoted by a ratio which we call the margin ratio requirement. For typical small accounts, it is usually 100%.
This can be very dangerous when the market is going against you. Therefore, make sure you are clear about the margin requirements and liquidation policies of your broker. This is very different from other kind of margin-based equity trading where the brokers would issue margin calls. Your Forex account can just vaporize overnight without you realizing!
Unrealized and Realized Forex Trading Profit and Loss
So you have bought a currency pair. And just as you hoped, the price went up higher. At this point, if you sell immediately, you would gain some profit. But until you have really sold it, we call it unrealized profit.
Same for losses for other positions, until you close your positions, your profit and loss are considered unrealized and calculated with the market price at that point of time.
When you square up your positions, the profit and loss goes to your margin balance. These profit and loss are realized.
Forex prices fluctuate constantly, and hence your unrealized profit and loss and your margin balance.
Forex Pips Explained
Forex Pips or points are the smallest units of currency prices increase or decrease. Forex profit and loss are calculated in terms of number of pips. For some pairs, the norm is to trade in 1/10 pips or 0.5 pips.
Major currency pairs are usually quoted in 5 significant figures. For example, EUR/USD 1.3776
If it goes from 1.3776 to 1.3777, it has gone up by 1 pip. If it goes from 1.3776 to 1.3775, it has gone down by 1 pip.
For this pair and most other pairs, 1 pip equals 0.0001.
If you bought 10,000 EUR/USD and the pair went up for 1 pip, your unrealized profit equals 10,000 x 0.0001 = USD 1
Forex Profit and Loss are denominated in the base currency.
Remember,
if you are in a long position, price increase means profit while decrease means loss;
if you are in a short position, price decrease means profit while increase means loss.
These are all based on the “buy low, sell high” or “sell high, buy low” principle.
If you are trading non-US pairs, your profit and loss are still denominated in the base currency. So if your margin balance is in USD which is common, you need to convert the profit or loss back to USD with the exchange rate at the moment.
Forex Profit and Loss and Margin Requirement
The last thing you want to see for your margin account is that it falls below the required ratio and positions be liquidated by the brokerage. To prevent this from happening, we need to be clear with pips and profit and loss calculations so that the trade or position you are about to enter is not too big.
Always keep an eye on the price point at which your account would fall below the margin requirement. One of the most stupid but sadly common mistake a forex trading beginner could make is to set his stop-loss price below that price point. It will never reach the stop-loss, because the position will have been liquidated before it got there!