Understanding the Trades
The best way to understand what happens in a forex trade is to demonstrate by way of example.Â In this case we will outline a trade in which we buy EUR/USD at 1.2100.Â
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).Â 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)
<Pay USD Overnight Rate>
Convert USD to EUR at 1.2100
Deposit 100,000 EUR
<Earn EUR Overnight Rate>
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.Â If the exchange rate increased, then we would have Dollars left over, which would be our profit.Â 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)Â 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.Â 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:
Unwind 100,000 EUR/JPY long
(Entered trade at 131.00)
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.Â That is our profit, but as USD-based traders we need to convert that back in to USD for our accounting purposes.Â That happens by exchanging the JPY for USD at the current USD/JPY rate.Â If that rate is 107.00, then we have a gain of $934.58 on the trade (100,000/107.00).Â 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:Â
Non-USD Base (i.e. EUR/USD):Â
Long:Â (Units x R2) – (Units x R1)Â or Units x (R2â€”R1)
Short:Â (Units x R1) – (Units x R2)Â or Units x (R1â€”R2)
Where R1 is the starting rate and R2 is the ending one.
Ex: Buy 100,000 EUR/USD at 1.3000 and sell at 1.3100:
(100,000 x 1.31 = $131,000)â€”(100,000 x 1.30 = $130,000) = $1000
USD Base (i.e. USD/JPY):Â
Long:Â ((R2/R1) – 1) x Units
Short:Â ((R1/R2)Â – 1) x Units
Long Ex: Buy 100,000 USD/JPY at 110.00 and sell at 111.00:
(( 111.00 / 110.00 ) – 1) x $100,000 = $909.09
Short Ex: Short 100,000 USD/JPY at 110.00 and cover at 109.00:
(( 110.00 / 109.00 ) – 1) x $100,000 = $917.43
As we know from the EUR/JPY example, cross trades require an additional step.Â The same calculation can be used as above (the non-USD base is probably the easiest, though either could be used), but the Profit/Loss figure would then have to be converted using one of the currencies involved to get it back to the account currency as demonstrated earlier.
Remember, forex trades have an interest rate carry based on the interest rate differentials.Â This can be either positive or negative. For longer-term trades, this can be a significant influence on the final P&L.
Multiple Open Positions
A common piece of advice offered by experienced forex traders to novices is to focus on one currency pair and stick to that.Â There are two reasons.Â One is to develop a good understanding of one forex relationship and not spreading things too thin.Â The other reason is to avoid some of the issues which can crop up when a trader has positions open in multiple currency pairs.
The first of those issues is creating excessive exposure to one currency.Â This is done by going long or short the same currency in different pairs.Â For example, I you were to sell EUR/USD and at the same time buy USD/JPY you would have two USD long positions.Â In shorting EUR/USD you are going long USD, and obviously in buying USD/JPY you are doing the same thing.Â This is a very quick way to put your trading account at serious risk if you are not aware of your total exposure.Â If the USD were to suffer a decline you would likely lose on both those positions.
The other issue in holding positions in multiple currency pairs is that you can accidentally create a position completely different than what you intended.Â For example, if you were to buy EUR/USD and buy USD/JPY the USD exposure in those trades would at least partially offset each other (you are selling USD in the first trade and buying it in the second), depending on the values of the two trades in question.Â What you are left with is a long EUR/JPY position, which has very different trading characteristics than either EUR/USD or USD/JPY.
The combination of the risk factor and the offsets that can happen is why even experienced traders often will only carry one open forex position at a time.Â It just keeps things simpler.