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Some forex brokers describe their gearing in terms of a leverage ratio and others in terms of a margin percentageThe Calculating Trader Here is where the rubber meets the road. Take your time with this information, as it is necessary knowledge for all FOREX traders. I recommend that you do not even paper trade until you are completely comfortable with pip values and calculating profit and loss for any pairs or crosses you intend to trade. Profit and Loss (P&L) for every open position is calculated in real-time on most brokers trading platforms. The information in this chapter enables traders to track their own P&L tick by tick as the market fluctuates. It is true your brokers trading platform is capable of making all these calculations. But there will be many times when you will want to make them onthe-fly as in the instance of verifying that an anticipated position meets your money management criteria. (See Chapter 15, Money Management Made Simple.) You simply cannot be an informed and intelligent FOREX trader without knowing these basic calculations. Use the tools on your brokers trading platform as practice for these calculations, not as a substitute for them. These calculations provide mission-critical information about the relationship between several key factors: pip values, dollar values, leverage, and margin. TIP: If arithmetic is not your thing, take one of these at a time and learn them over several sessions. Use your brokers demo account to practice. Do the calculation on your own; then do it on the trading platform as a check. If you do not have a demo account, both www.forexcalc.com and www.oanda.com offer online FOREX calculations covering at least some of these equations. Leverage and Margin Percent Some brokers describe their gearing in terms of a leverage ratio and others in terms of a margin percentage. The simple relationships between the two terms are: Leverage = 100 / Margin Percent Margin Percent = 100 / Leverage Leverage is conventionally displayed as a ratio, such as 20:1 or 50:1. In the examples that follow which require leverage, I use only the number on the left side of the ratiothat is, 20 or 50since the number on the right side is always 1. Pip Values A pip is the smallest price increment that any currency pair can move in either direction. In the FOREX markets, profits are calculated in terms of pips first, then dollars second. Approximate USD values for a one-pip move per contract in the major currency pairs are shown in Table 6.2, per 100,000 units of the base currency. On a typical day, actively traded currency pairs like EUR/USD and USD/JPY can fluctuate 100 pips or more. The above table is based upon a margin requirement of 100 percent (leverage = 1:1). To calculate actual profit (or loss) in leveraged positions, multiply the pip value per 100k times the leverage ratio (margin percentage divided by 100). Note that the EUR/GBP cross rate pair in Table 6.2 uses multiplication with the USD spot price instead of division. This is because the USD is the quote (second) currency in the spot conversion pair. Calculating Profit and Loss Many FOREX trading platforms offer their clients a variety of online utilities that assist the investor in his or her trading calculations. The utility to compute the profit or loss on each trade should resemble what is shown in Figure 6.1. Because all profits are expressed in U.S. dollars, a key factor in the calculation of profit and loss is the currency pair and whether the USD is the base currency or the quote currency, or if the currency pair is a non-USD cross rate. Therefore, I will present several examples involving all cases. Remember that the first currency in a currency pair is called the base currency (determines the number of units traded) and the second is called the quote currency (determines the pip values of each price change). TIP: Always make sure that what you mean by any term is the same as what your broker-dealer means by that term. Definitions do vary, usually slightly. But even a small difference can lead to an error. Scenario 1 USD Is the Quote Currency (Profit) Currency pair. Select the corresponding currency pair from the dropdown list. The default is the EUR/USD pair. Position. Choose either buy or sell. The default is buy. Number of units. This is the individual number of units and not the number of lots or mini-lots. A full lot should be entered as 100000 and a mini-lot as 10000. Entry price. This is the entry price regardless if the trade was a market order or a limit order. Include the decimal point. Exit price. This is the liquidation price regardless if the trade was manually exited or a limit order was triggered. Conversion rate. This entry is necessary to convert any profit or loss to U.S. Dollars if the quote currency (the second one in the pair) is not USD. In this example, USD is the quote currency. Enter the single digit 1 since we already have conversion parity. Other possibilities are explained later. Click the Calculate button as shown in Figure 6.2. In this example we bought a mini-lot (10,000 units) of the EUR/USD pair at 1.2563 and sold at 1.2588, netting a clear profit of 25 pips (price change times pip factor, or 0.0025 10,000). The price change is simply: Price Change = Exit Price - Entry Price The pip factor is the number of pips in the monetary unit of quote currency. There are 10,000 pips in one U.S. Dollar and, conversely, a single pip equals $0.0001. The pip factor is therefore 10,000. Profit in Pips = Price Change Pip Factor When the quote currency is the USD, profit or loss is calculated very simply as: Profit in USD = Price Change Units Traded Many of you have just exclaimed Wow! That was painlessly simple. Show me one more! Scenario 2 USD Is the Quote Currency (Loss) For those of you who exclaimed nothing or are staring blankly at this page, we will do it again, this time with the GBP/USD currency pair. See Figure 6.3. In this instance, we initiated a 30,000-unit short (sell) trade in the GBP/USD pair at 1.8863 and, sadly, it advanced against our hopes. We exited at 1.8883, losing 20 pips. Since the quote currency (the second currency) is USD, we know the conversion rate is 1. Thus using the profit formula Profit in USD = Price Change Units Traded we find that our profit is actually a loss before, these calculations only require the four simple arithmetic functions: addition, subtraction, multiplication, and division. No exponents, logs, or trig functions. But this information must be completely clear before proceeding. Keep in mind that it is your money at stake. Scenario 3 USD Is the Base Currency (Profit) If the quote (second) currency is not the U.S. Dollar, then profit or loss must be converted to U.S. Dollars. For example, a 35-pip profit in the USD/JPY pair means that the 35 pips are expressed in Japanese Yen (see Figure 6.4). Therefore, one extra step is required to convert Yen to Dollars: Conversion Rate. If USD is the base currency of the currency pair being calculated, then divide the profit or loss by the exit price. This simply converts the pip profit expressed as Yen to a profit expressed as Dollars. Thus, when calculating currency pairs where the base (first) currency is the U.S. dollar, the profit formula must be adjusted as follows: Profit in USD = Price Change Units Traded / Exit Price or, specifically: Scenario 4 USD Is the Base Currency (Loss) This example is arithmetically identical to the previous example, except that a small loss was incurred. We purchased 5,000 units of the USD/CAD pair at 1.3152 and set a stop-loss limit order at 1.3142, which, unfortunately, was triggered (see Figure 6.5). Using the same adjusted profit formula as in the previous example, Profit in USD = Price Change Units Traded / Exit Price we find: Scenario 5 Non-USD Cross Rates (USD/Quote) Most experienced traders can mentally perform the arithmetic in the above examples. It just takes practice. However, we must now tackle cross rates, currency pairs where neither currency is the U.S. Dollar. Obviously the profit in pips will be initially expressed in terms of the quote (second) currency of the cross rate pair. The solution is simple: Look up the current price of the currency pair containing USD and the quote currency of the cross rate pair The Conversion Rate entry of 105.32 in Figure 6.6 is actually the current price of the USD/JPY pair. The adjusted profit formula for this cross rate trade is: Profit in USD = Price Change Units Traded / Conversion Rate or $37.98 = 0.40 10000 / 105.32 A pattern is developing here . . . Scenario 6 Non-USD Cross Rates (Base/USD) In the previous example, the USD was the base currency in the conversion pair (USD/JPY). In Figure 6.7 USD is the quote currency of the conversion pair (GBP/USD). The Conversion Rate entry in Figure 6.7 is the current price of the GBP/USD pair. The reversal of the role of the U.S. Dollar in the conversion pair (GBP/USD) requires another change in the profit formula: Profit in USD = Price Change Units Traded Rate or $19.05 = 0.0018 20000 Remember that when USD is the quote currency of the conversion pair, you must multiply the rate. If USD is the base currency of the conversion pair, then divide the rate. Give yourself an A+ if you understood the previous examples on the first reading. You are destined for great things. You may have noticed there was no mention of transaction costs in the six scenarios given. The broker always subtracts the transaction cost at the moment the trade is initiated; therefore transaction costs do not affect the above calculations. Calculating Units Available Before initiating a new trade, it is always advantageous to know the maximum number of units that you can safely trade without risking a margin call based upon your current account balance. Most trading platforms provide an online utility that calculates this information, usually resembling what is shown in Figure 6.8. Enter the following data fields to calculate the maximum number of units to buy or sell: Margin available. This is the amount in your margin account you want to earmark for the current trade. Margin percent. This is your brokers margin percentage for leveraging trades. Currency pair. Select the corresponding currency pair. In this example, select EUR/USD. Current price. Enter the current ask price in the currency pair. Conversion rate. If the quote currency in the selected currency pair is USD, then enter 1. You can safely trade 15,000 units of EUR/USD in this example. In the next example (Figure 6.10), we calculate the units available for a currency pair in which the base currency is USD. Enter the first four fields as in the previous example. Since USD is the base currency in the USD/JPY pair, we must enter the current price as the conversion rate. The formula to calculate the maximum units that can be traded is: Units Available = 100 Margin Available Rate / (Current Price Margin Percent) If USD is the base currency, then this reduces to: Units Available = 100 Margin Available / Margin Percent Cross rates can be handled in the same fashion by simply manipulating the conversion rate. Note: Always decrease the units available slightly to avoid a margin call. I recommend 10 percent. Calculating Margin Requirements Before executing any trade, you should always have a rough idea of how much of your account balance will be used as the margin requirement. Any trade whose margin requirement exceeds your existing account balance will not be executed. Trades whose margin requirements deplete nearly all the equity in your account are very risky and may incur the dreaded margin call. The formula to calculate the margin requirement for a trade is very simple: Margin Requirement = Current Price Units Traded Margin Percent / 100 Assume your broker mandates a 5 percent margin percentage. You want to buy a full lot (100,000 units) of the EUR/USD currency pair, which is trading at 1.2538. Thus: $6,269.00 = 1.2538 100,000 5 / 100 This trade requires $6,269.00 for margin. Proceed accordingly. Calculating Transaction Cost Your broker will always calculate the transaction cost because that cost is automatically subtracted from your account balance the instant you initiate a new trade. Nonetheless, it is useful to know just how the broker computes this debit. Remember that the bid price is used when the trader initiates a new buy (long) trade and the ask price is used when the trader initiates a new sell (short) trade. When the USD is the quote currency in the currency pair, the conversion rate equals 1, as seen in Figure 6.12. The basic formulas for the transaction cost in this instance are: Spread = Ask Price - Bid Price Cost = Spread Units Traded $3.00 = (1.2569 - 1.2566) 10,000 An example in which we calculate the transaction cost when the base currency is USD. In this case, the formula becomes: Spread = Ask Price - Bid Price Cost = Spread Units Traded / Ask Price $3.24 = (1.2359 - 1.2355) 10,000 / 1.2359 In our final example, we calculate the transaction cost in U.S. Dollars for a non-USD cross rate. We need to look up the current price of the currency pair containing USD and the quote currency of the cross rate Calculating Account Summary Balance In this section, I make the following assumptions before walking you through the accounting system of your first trade: You have read and thoroughly understand the FOREX trading terms. You have researched a half dozen or so reputable FOREX brokers and selected one that satisfies your financial needs and goals. You have used the brokers paper trading feature and/or the demo program that he or she provides and now feel comfortable with the screen layout of the trading platform and its mouse/keyboard navigation system. You have opened a new margin account, signed and returned the necessary application forms, and deposited 5,000 USD with the broker. You are now ready to make your first trade in the FOREX currency markets. The Account Summary section of your brokers trading platform should look similar to what is shown. Let us say that your new broker offers 20:1 leverage, which means that you must risk five percent of the total value of any trade that you execute, long or short. Assume that you have analyzed, both technically and fundamentally, several major currency pairs and feel that the USD/JPY pair is overpriced and it will decline in the immediate future. You now execute a very conservative entry order to sell 5,000 units of USD/JPY at a market price of 105.64. The transaction cost (the difference between the bid and the ask price) is three pips for the USD/JPY pair. We see that the Balance and the Realized P&L entries are unchanged. Unrealized P&L show a negative 1.42 USD. This is the round-turn transaction cost, which is subtracted the moment a new trade is executed. Each pip in the USD/JPY trade is worth 0.4733 USD. Therefore: 1 pip = 1/105.64 50 1 pip = 0.4733 USD 3 pips = 1.4199 USD Margin Used entry shows 250.00 USD, calculated as follows: Margin Used = Total Cost of Trade Margin Percentage 250.00 = 5,000.00 5% The Margin Available entry has also changed: Margin Available = Balance - Margin Used 4,750.00 = 5,000.00 - 250.00 After ten minutes or so, we notice that your feelingthat the USD/JPY pair was oversold and would declinehas paid off. The USD/JPY has dropped to 105.51. Not only have you recouped the transaction cost (minus three pips) but you gained a plus 10 pips in profit, as shown in Figure 6.17. At this point, market activity slows down and the price direction starts moving laterally. You decide that a plus 10 pips on your first trade is satisfactory and you close the trade. Essentially, this means purchasing 5,000 units of USD/JPY to offset your previous sale. Once your trade liquidation is logged at the brokers firm, your new Account Summary should resemble what is shown in Figure 6.18. The example, of course, is merely an illustration. Your first trade may be greater or smaller than the example. For Futures Traders Futures traders tend to think in dollars versus a commodity asset (silver, soybeans, pork bellies, etc.). The switch to corelational valuesone currency against anothercan be a bit trying at first. The trick is to practice calculating profit and loss for fictitious trades. Most broker dealing platforms provide such a calculator. Summary The math in this chapter is not nearly as complex as it may appear at first. In fact I can reduce it all to the following cheat sheet: Price Change = Exit Price - Entry Price Leverage = 100 / Margin Percent Margin Percent = 100 / Leverage Profit in Pips = Price Change Pip Factor If the Quote Currency in a trade = USD, then Profit in USD = Price Change Units Traded If the Base Currency in a trade = USD, then Profit in USD = Price Change Units Traded / Exit Price When the profit for non-USD cross rates is being calculated, the following applies: The conversion rate is the currency pair with the USD and the quote currency of the cross rate pair. the base currency of the conversion rate = USD, then Profit in USD = Price Change Units Traded / Conversion Rate If the quote currency of the conversion rate = USD, then Profit in USD = Price Change Units Traded Conversion Rate You can now calculate profit and loss during open positions. Learning these basic calculations will endue you with confidence, something you will need in substantial measure to succeed as a currency trader. Practice calculations with the calculator available on most broker web sites (see Chapter 7) or at www.forexcalc.com. |
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