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Foreign exchange delivers a platform for informed traders to speculate on exchange rate fluctuations.
Consistently profitable traders understand the necessity for a well-defined trading plan and risk-management approach. It is also good practice to recognise the calculations behind specific key parameters, such as pip value, margin, swaps and profit and loss.
Profit and loss, or P&L, is an important value to understand in any business.
Margin and Leverage
- Margin is a deposit (a small percentage of an account) required by CFD/Forex brokers to open (and maintain) positions in the Forex market (referred to as Used Margin or Initial Margin). Think of it as a safety measure to guard each party within the agreement. Provided equity (account balance) remains above margin, the brokerage’s stop-out level will not be impacted.
- Leverage represents a ratio. 1:100 leverage, for instance, means for every 1 USD traders have in their account, they’re able to essentially control up to 100 USD.
Leverage ratios offered by Forex brokers governs the margin required (1 / 100 = 0.01, or 1.00 percent margin).
The point is, a trader’s P&L influences an account’s margin balance, free margin. Free margin (or available margin) represents available capital for additional positions, and the value open positions can move against a trader.
Forex Trades: Calculating P&L
Although Forex calculators remain popular, manually calculating P&L is straightforward.
The basic (minus any commissions or swaps) calculation involves multiplying position size (units traded) by pip movement.
As an example, assume the EUR/USD (any currency pair can be used, such as GBP/USD or USD/CHF) currency pair trades at a current rate of $1.2255. Trader A is long (buy) 500,000 units of euro (the base currency – always represents 1 unit) and Trader B is long 50,000 units of euro. The base currency is always the currency that’s traded. The quote currency (the second currency listed in a currency pair) provides the value, or cost, to purchase the base currency.
100,000 units represents 1 standard lot, while 10,000 units equates to a mini lot. Along with a micro lot (1,000 units), these are standard position sizes. Though they’re not fixed. Traders are free to trade 15,000 units or 25,000 units, for example.
Both Trader A and B have accounts denominated in US dollars (USD): an account currency identical to the currency pair’s quote currency.
EUR/USD advances from $1.2255 to $1.2275. This represents a 20-pip gain. Trader A gains 1,000 USD (500,000 * 0.0020) and Trader B, 100.00 USD (50,000 * 0.0020).
EUR/USD declines from $1.2255 to $1.2210. This represents a 45-pip loss. Trader A is down by 2,250 USD (500,000 * 0.0045) and Trader B is also down 225.00 USD (50,000 * 0.0045).
The problem arises when the account is denominated in the base currency of the currency pair. However, the calculation is simple. Using Trader A’s loss as an example, traders can multiply trade size (in euros [500,000 / $1.2255]) by pip movement (407,996 x 0.0045) to get the loss value in euros.
If the account’s currency is denominated in a currency not included in the currency pair traded, this involves substituting the currency pair’s base currency for the account currency. The trader is then free to calculate P&L in the same way as the aforesaid calculation.
Forex Trades: Calculating P&L Using Pip Value
Another method of calculating P&L is multiplying pip value by pip movement.
A pip (price interest point or percentage in point) is a currency pair’s unit of change, equal to 1/100th of 1%. Aside from currency pairs holding Japanese yen (JPY – priced to two decimal places [0.01]), most are priced to four decimal places (0.0001).
An account denominated in the same currency as the quote currency (USD in this example) has pip values ranging from 0.10 USD (for 1 micro lot [1,000 units]), 1.00 USD (for 1 mini lot [10,000 USD]) and 10.00 USD (for 1 standard lot [100,000 USD]). So, for Trader A’s long position that rallied 20 pips can be calculated by multiplying 50.00 USD by 20 (100,000 units equates to 10 USD pip value, so 500,000 units represents 50.00 USD pip value).
If the account currency is identical to the base currency, pip value is found by dividing one pip (0.0001) by the currency pair’s exchange rate and then multiplying this value by the lot size (units traded). For an account currency not included in the currency pair traded, it’s necessary to exchange the account currency for the base currency. Traders are then free to calculate pip value using the aforesaid calculation.
Disclaimer: The information contained in this material is intended for general advice only. It does not take into account your investment objectives, past performance, financial situation or particular needs. FP Markets has made every effort to ensure the accuracy of the information as at the date of publication. FP Markets does not give any warranty or representation as to the material. Examples included in this material are for illustrative purposes only. To the extent permitted by law, FP Markets and its employees shall not be liable for any loss or damage arising in any way (including by way of negligence) from or in connection with any information provided in or omitted from this material. Features of the FP Markets products including applicable fees and charges are outlined in the Product Disclosure Statements available from FP Markets website, www.fpmarkets.com and should be considered before deciding to deal in those products. Derivatives carry a high level of risk; losses can exceed your initial payment. FP Markets recommends that you seek independent advice. First Prudential Markets Pty Ltd trading as FP Markets ABN 16 112 600 281, Australian Financial Services License Number 286354.