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

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 (R2)