Chapter 14. Calculation of profits and losses

So far, we have already thoroughly studied the basic terms and concepts used in Forex, as well as the principle of margin trading. Now it is time to learn how to calculate profits and losses on completed deals.

 

We know that an Internet trader enters the international currency market through a dealing company, which opens an account in US dollars. To work on Forex, the trader must transfer an initial amount of money to this account. All profits and losses from completed transactions, regardless of the currency of the transaction, are converted into US dollars. In this chapter, the principle of calculating profits and losses will be discussed in detail.

In general, the formula for calculating the financial result of a transaction can be written as follows:

financial result = (selling price – buying price) * number of lots * lot size – commission * number of lots ± bank interest

As we can see, the financial result is made up of three parts: trading result, commissions paid and bank interest.

We already know that there are two types of quotes on Forex (not counting cross rates) – direct and reverse. In the first case, the base currency of the quote is a foreign currency against the dollar and is expressed (quoted) in dollars. In the second case, the dollar itself is the base currency of quotation and is expressed in units of foreign currency. The trading result in the above formula is calculated in the quoted currency. Commissions and bank interest, as a rule, are expressed in dollars, so the formula is valid only for direct quotations. It should be noted that in this formulation, the selling price and the buying price are not components of the quotation, but the real price for which we sold and bought the currency, regardless of what transaction was earlier (buying or selling). If the financial result is positive, we make a profit. If it is negative, we make a loss.

For a reverse quote, the difference between the buy and sell price is expressed in foreign currency, while the total financial result is expressed in dollars. Therefore, the following formula is used to calculate the financial result for reverse quotes:

financial result = (1/buy price – 1/sell price) * number of lots * lot size – commission * number of lots ± bank interest

The lot size depends on a particular quote (of currency pairs) and on the preferences of a particular Internet broker. The above formulas are used if the lot size is expressed in a foreign currency (not in US dollars). For example, the lot size for a GBP/USD forward quote could be 70,000 British pounds sterling. Or the lot size of a USD/JPY reverse quote could be 12,500,000 Japanese Yen. If your online broker specifies the lot size in dollars, in order to use the above formulas, you will need to convert dollars into the appropriate currency. The lot size in foreign currency will not be fixed, but will depend on the current exchange rate at the moment of position opening. In US dollars, the standard lot size is almost always 100,000.

The calculation of the financial result at cross rates is slightly different. As we discussed in the relevant chapter, cross rates are exchange rates of currencies against each other, excluding the US dollar. Any cross rate can be represented by two dollar quotes. For example, a EUR/JPY cross rate can be calculated through a EUR/USD quote and a USD/JPY quote. Calculation of profit and loss in this case is as follows. First, the financial result for the EUR/USD quote is calculated, and then the financial result for the USD/JPY quote is calculated. These financial results are added up to get the total financial result.

 

As we know, forex exchange rates change in pips. The size of a pip varies from quote to quote. When opening a position, it is important to know what trading result is brought to us by the change of the exchange rate by one point in dollar equivalent. This will allow us to evaluate our current profits or losses and close the position in time. Using the above formulas this value is easily calculated and depends on the type of quote (direct or reverse), the size of one lot, the currency in which the lot is expressed and the size of one point.

Let’s consider a straight quote GBP/USD with a lot size of 70 000 GBP and a pip size of 0.0001. Since the quote is straight, we use the first formula to calculate the trading result. The minimum difference between the buy price and the sell price is always one pip, and in this case it is 0.0001. So, the trading result from the change of GBP/USD rate on one lot by one point is equal to 0.0001 * 70 000 = 7 USD.

Let’s consider a reverse USD/JPY quote with one lot size of 12,500,000 Japanese Yen and a pip size of 0.01. Since the quote is reverse, we use the second formula to calculate the trading result. Knowing the value of one pip in the case of a reverse quote is not enough, because the trading result depends on the values of the buy and sell prices themselves. Let’s assume that the current value of the exchange rate is 104.75 Japanese Yen per USD. Then the trading result from the change of USD/JPY rate for one lot by one point is equal to (1/104.75 – 1/104.76) * 12,500,000 = 11.39 USD. It should be noted that at different buy and sell prices we get different trading result. If the lot size was expressed in dollars, it would have to be converted into Yen at the corresponding exchange rate at the moment of position opening. Moreover, if a long position was opened (buying dollars for Yen), the selling rate would be used for calculations, and if a short position was opened (selling dollars for Yen), the buying rate would be used.

As we can observe, changing the rate by one point in different quotes gives different trading results. In GBP/USD quote it is less than in USD/JPY quote. The smaller the trading result from a one-point change in the rate, the smaller losses you will incur in case of an unfavorable change in the rate. But on the other hand, the less will be your profit if the rate changes in the desired direction. Beginning Internet traders are recommended to work with less “aggressive” quotes, such as GBP/USD and USD/CHF.

At first glance, the calculation methods discussed in this chapter may seem too complicated. But there is no point in worrying about it, as all calculations related to profits and losses are performed automatically by the trading platform. Different dealing companies use different trading platforms, but the principle of calculations does not change. It is important for you to understand what your profits and losses are made up of, so that you do not close a position with losses by mistake!