We have thoroughly considered the basic terms used on Forex and the main principles of margin trading. It is the time to study how to calculate profit and loss of the opened trades.
We know that a trader enters the international currency market with the help of a dealing company, which opens an account for a trader in the US dollars. To be able to work on Forex, traders should transfer the initial amount of money to this account. All profits and losses regardless of the currency of a deal are converted into the US dollars. In this chapter we will consider in detail the principle of the profit and loss calculation.
In general, the formula for calculating the financial result of your opened deals is the following:
Financial result = (buy price – sell price) * number of lots * lot size – commission * number of lots ± swap
Obviously, the financial result consists of three parts: trading result, commissions, and the swap size.
We know that there are two types of quotes on Forex (not taking into account cross rates) – direct and indirect. In the first case, the base currency in a pair is a foreign currency against the US dollar, and the quote is expressed (quoted) in the US dollars. In the second case, the US dollar is a base currency in a pair, and the quote is denominated in a foreign currency. The trading result in the above-mentioned formula is calculated in the quoted currency. Commissions and swaps are usually denominated in the US dollars. That is why the formula is true only for direct quotes. It should be mentioned that in this formula, buy and sell prices are not components of the quote. They are real prices at which we buy or sell a currency. Notably, we do not take into account which operation was performed first (buy or sell). If the financial result is positive, we get profit. If it is negative, we lose.
In case of indirect quotes, the difference between buy and sell prices is expressed in the foreign currency, while total financial result is in US dollars. Thus, to calculate the financial result for indirect quotes, we should use the following formula:
Financial result = (1/buy price – 1/sell price) * lots number * lot size – commissions * lots number ± swap
The lot size depends on a certain quote (on a currency pair) and on the preferences of a particular online broker. The formulas presented above are used if the lot size is denominated in a foreign currency (not in the US dollars). For instance, the lot size in the direct quote of GBP/USD can be £70,000. The lot size of the indirect quote of USD/JPY can be ¥12,500,000. If your online broker designates the lot size in the US dollars, then you will have to convert the US dollars into the appropriate currency. In such cases, the lot size denominated in a foreign currency will not be fixed but will depend on the current rate at the moment of opening a position. In the US dollars the size of the standard lot usually equals 100,000.
Estimation of the financial result on cross rates is different. As we have learnt from the previous chapter, cross rates are the currency exchange rate between two currencies when neither is the US dollar. Any cross rate can be represented by two quotes with the US dollar. For instance, cross rate EUR/JPY can be calculated by the EUR/USD and USD/JPY quotes. Calculation of profit and loss is the following. Firstly, you should calculate the financial result for EUR/USD, then for USD/JPY. These results are summed up for getting total financial results.
As we all know, a movement in the exchange rate is measured by pips. In different quotes the pip value is different. Opening a deal, you have to know the result in the US dollars if the price changes by 1 pip. It will help you to assess your current profit or loss and close the position in time. You can easily do it using the formulas given above. The value will depend on the type of quote (direct or indirect), lot size, the currency of a lot value, and a pip value.
Let us consider the GBP/USD pair if 1 lot equals 70,000 pounds sterling and 1 pip equals 0.0001. As the quote is direct, we use the first formula to calculate the trading result. The minimum difference between buy and sell price is always 1 pip, and in this case, it equals 0.0001. Thus, the trading result of 1 lot of the GBP/USD rate change by 1 pip is 0.0001 * 70,000 = 7 US dollars.
Let us inspect the indirect quote USD/JPY with the lot size of 12,500,000 yen and the pip value of 0.01. As the quote is indirect, we use the second formula to assess the trading result. It is insufficient to know only a pip value in case with indirect quotes, because a trading result depends also on buy and sell prices. Suppose that the current rate is 104.75 Japanese yen for one US dollar. Thus, if the price of 1 lot changes we will have the following result: ((1/104.75 – 1/104.76) * 12,500,000 = 11.39 US dollars. If buy and sell prices are different, the trading result will also be different. If a lot size is denominated in the US dollars, we have to convert it into the Japanese yen by the price that we have at the moment of opening the position. And if you open a long position (buying 1 lot of the US dollars for the yen), the calculations would be carried out using the sell price, and if it is a short position (selling 1 lot of the US dollar for the yen), calculations depend on the buy price.
As we can see, changes in the price of different currency pairs by one pip leads to various trading results. For GBP/USD it is less than for USD/JPY. The smaller the trading result is, the less losses you will suffer in case of unfavorable price movement. Notably, your profit will also be smaller. Beginning traders are recommended to choose less “aggressive” quotes such as GBP/USD and USD/CHF.
At the first glance, calculations presented in this chapter may seem too complicated. In fact, you do not have to worry as all estimates are made by the platform automatically. Brokerage companies may offer various trading platforms, but the principle of the calculation remains the same. It is important to know what your profits and losses consist of. This will allow you to avoid closing a deal with losses by mistake!