Someone once asked and she said,
“I do not know how these people [brokers] calculate our profit and loss, it looks strange too me, as I feel they are cheating me”.
So many people have ended up calling forex a scam and have the feeling they are being cheated, that’s because they simply have no fundamental knowledges on how these things act or work, the way they do work in forex, similar to trading stocks, and other financial assets they work using the same principal.
Let me give an example on how to calculate profit and loss in forex trading
Let’s buy 1 lot (contract size) US dollars and Sell Swiss Francs (USD/CHF).
The exchange rate quoted is 1.40525 / 1.40530. Because you are buying the US Dollar at 1.40530, you will be looking forward to sell that at any price that is greater than 1.40525, so as to be able to realize profit.
Do not forget you bought 1 lot (contact size) which is 100,000 unit of currencies at 1.40525 that’s approximately you bought 140,525 unit of US Dollar and you are hoping to sell that same unit of currencies you had bought at a higher rate than you had initially bought from.
In case you didn’t understand what happened there, don’t worry I will try to explain it a little bit to you.
When you trade forex you trade using lot or contract size which specify the quantity or unit of the currency you want to buy and from the example above, we bought 1 lot of US Dollar and to be able to get the quantity using the current currency units or currency, we must multiply it using the exchange rate that is 100,000 (lot size)* 1.40530 (exchange rate) = 140,525 unit of US Dollar.
After some hours,
The price moves to 1.40611/ 1.40616, which has before the new quote for USD/CHF.
This price looks good to you, and you decided at this current rate then to wait for uncertainty in the market. Since you’re closing your trade, you had initially bought the USD/CHF at 1.40525/ 1.40530 and the current price is 1.40611/ 1.40616, that is we had bought at 1.40525 and we are going to sell at 1.40616.
To be able to calculate our profits ourselves and not be in the mercy of anybody, we need to know the differences between the price we bought at and the price we are going to be sell at to be able to know the pips.
The difference between our buying price and sold price is 1.40525 – 1.40616 is = 0.00091 equivalent to 9 pips.
To know how the dollar value of each pips, we will use the formula below (NOTE that in pairs such as a EURUSD, which USD as the quote currency is calculated different, same goes for USDJPY with JPY as the quote currency, these pair are calculated different.)
0.00010 (one pip) /Exchange rate *Lot size
Using our formula from above, we now have (0.00010/1. 40616) x $100,000 = $7.111 per pip.
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To get the value of the 9pips, we will calculate it this way: 9 pips x 7.111 per pips = $63.999.
Now, we have a sufficient knowledge on how to calculate our profit or loss when trading forex and we do not need to rely on any 3 party to do the calculations for us.
If you are using a trusted broker, you can accept their own calculation since they are supervised and regulated by good regulatory body.
If you are wondering why there is a difference between the Bid and the Ask price that is, 1.40611/ 1.40616 and 1.40525 / 1.40530 – the difference between those two exchange rate is equal to 0.00005 which is called a point or pipette (one tenth of a pip). The difference is called a Spread as this is transaction cost your broker charges for any trade you open or exit.
When you buy a currency, you pay the spread as you enter the trade but not when you exit. And when you sell a currency you don’t pay the spread when you enter but only when you exit.
REMEMEBER: that in pairs such as a EURUSD, which USD as the quote currency are calculated differently, same goes for pairs like USDJPY with JPY as the quote currency, these pair are calculated differently too.
NOTE: When you buy a currency you will use the Ask price and when you sell you will use the Bid price.