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FXstreet.com
Part IV: Understanding Positions & Profits
Understanding the Trades
The best way to understand what
happens in a forex trade is to demonstrate by way of example. In this case we
will outline a trade in which we buy EUR/USD at 1.2100.
Remember, when buying or selling in
the forex market you are doing so in regards to the base currency (the first one
listed in the pair). That means for EUR/USD we are long the Euro, and by
extension, short the USD.
This diagram shows the way the
transaction runs it's course:
Simple Spot Forex
Trade
Buy 100,000 EUR/USD at 1.2100
Borrow 121,000 USD (100,000 x $1.21)
||
Convert USD to EUR at 1.2100
||
Deposit 100,000 EUR
When we close out
this trade, it is a simple reversal process. The EUR position is converted back
in to USD and we pay-off the USD loan we took out. If the exchange rate
increased, then we would have Dollars left over, which would be our profit. For
example, if the rate went to 1.25 we would have $4000 left over after paying
back our loan (100,000 x $1.25 = $125,000 - $121,000 = $4000) If the rate had
dropped, we would have a shortfall on our loan repayment, and thus a loss on the
trade.
For a trader
whose account is denominated in US Dollars, the above example is pretty
straightforward. There is only one exchange happening each way. When one is
trading cross-rates, however, things get more complex.
Everything
remains essentially the same when we enter the trade. If, for example, we were
buying 100,000 EUR/JPY at 131.00 we would borrow 13,100,000 JPY (100,000 x 131),
exchange that in to EUR, and deposit it. We would pay interest on the JPY loan
and earn it on the EUR deposit, just like we did in the EUR/USD example.
The complexity of
a cross trade comes when unwinding the trade. Assume EUR/JPY rises to 132.00,
and see how the long position unwind would look:
Cross-Rate Trade
Unwind 100,000 EUR/JPY long
(Entered
trade at 131.00)
100,000 EUR
||
Convert EUR back to JPY at
132.00
(100,000 x 132 = 13,200,000 JPY)
||
Repay 13,100,000 JPY
(13,200,000 - 13,100,000 =
100,000 JPY remains)
You will note that there are 100,000 JPY
remaining after the original JPY loan is repaid. That is our profit, but as USD-based
traders we need to convert that back in to USD for our accounting purposes.
That happens by exchanging the JPY for USD at the current USD/JPY rate. If that
rate is 107.00, then we have a gain of $934.58 on the trade (100,000/107.00).
Of course, we must also take in to account the interest carry when determining
our net profit.
Calculating
Profits & Losses
The above
outlines of forex trades may seem complicated, but
as an individual trader,
you don't see all that stuff. When it comes down to determining your profit or
loss (P&L), it's pretty simple. The essence of determining one's P&L boils down
to starting value and ending value (as set by the market).
Here are the formulas for
calculating your profit or loss on a forex trade:
Non-USD
Base (i.e. EUR/USD):
Long: (Units x R2) -
(Units x R1) or Units x (R2â€"
