[MUSIC] Learning outcomes, after watching this video, you will have a clear understanding of how profit and loss works in currency markets. You will understand what margin balances are and what liquidation means. You will also be able to differentiate between unrealized and realized profit and loss. Profit and loss is how traders measure success and failure in financial markets. A clear understanding of how P&L works is especially critical to margin trading where your P&L directly affects the amount of margin you have to work with. Changes in your margin balance determines how much you can trade and for how long you can trade if prices move against you. So let's understand margin balances and liquidations. When you open a currency trading account, which is mostly online these days, especially for new investors like you and me, you will need to put cash as collateral to support the margin requirement. And the margin requirement is established by a broker. That initial margin deposit becomes your opening margin balance and is the basis on which all your subsequent trades are collateralized. Like in futures markets or margin based equity trading, forex brokerages, most of them do not issue margin calls, which are requests for more collateral to support open positions. Instead they establish ratios of margin balances to open positions that must be maintained at all times. So let's take an example to help us understand how required margin ratios work. Say you have an account with some broker with a leverage ratio of 100 is to 1. So, $1 of margin in your account can control $100 position size. When your broker requires 100% margin ratio, meaning, you need to maintain 100% of the required margins at all times. The ratio varies from account size, but 100% margin requirement is typical for small accounts. That means to have a position size of $10,000, you would need $100 in your account because $10,000 divided by the leverage ratio of 100, is actually $100. If your account's margin balance falls below the required ratio, your broker probably has the right to close out your position without any notice to you. If your broker liquidates your position, that usually means your losses are locked in, and your margin balance just got smaller. It's therefore very important for investors, retail investors especially like you and me to understand the broker's margin requirements and liquidation policies. Requirements may differ depending on account size and whether you're trading say a standard lot size, which is 100,000 currency units, or mini lot sizes, which are 10,000 currency units. Some brokers' liquidation policies allow for all positions to be liquidated if you fall below the margin requires. Others close out the biggest losing positions, or portions of losing positions until the required ratio is satisfied again. You can find the details in the fine print of the opening account contract that you signed. And most brokerages these days put it in really fine print, really small font. But it's important to always read the fine print to be sure you understand your broker's margin and trading policies. Also to understand what is called unrealized and realized profit and loss, so let's understand what is unrealized and realized profit and loss. Most forex brokers provide real time market-to-market calculation showing your margin balance. Market-to-market is the calculation that shows your unrealized P&L based on where you could close your open position in the market at that instant. Depending on your broker's trading platform, if you're long, the calculation will typically be based on where you could sell at that moment. If you're short, the price used will be where you can buy at that moment. Your margin balance is the sum of your initial margin deposit, your unrealized P&L, and your realized P&L. Realized P&L is what you get when you close out a trade position or a portion of a trade position. If you close out the full position and go flat, whatever you made or lost leaves the unrealized P&L calculation and then goes into your margin balance. If you only close a portion of your open positions, only that part of the trade's P&L is realized and goes into the margin balance. Your unrealized P&L continues to fluctuate based on the remaining open positions, as does your total margin balance. If you've got a winning position open, your unrealized P&L is positive, and your margin balance increases. If the market is moving against your positions, your unrealized P&L is negative, and your margin balance is getting reduced. Forex prices change constantly. So your market to market unrealized P&L and total margin balance also changes constantly. And how do you calculate P&L with PIPs? Profit and loss calculations are pretty straightforward, in terms of math. And they're all based on position size and the number PIPs you make or lose. Now what is this thing called as a PIP? A PIP is the smallest increment of price fluctuation in currency prices. PIPs are also referred to as points, we will be using the two terms interchangeably. Now let's just look at a few currency pairs to help us get an idea of what a PIP is. Most currency pairs are quoted using five digits. The placement of the decimal point depends on whether it's a yen currency pair, in which case there are two digits behind the decimal point. All of the currency pairs have four digits behind the decimal point. In all cases, that last itty bitty digit is the PIP. So let's take some major currency pairs and crosses and see what the PIP is. Say for instance that Euro dollar is at 1.2853, the last decimal point, 3, is called as the PIP. Let's say Swizzie USD CHF is at 1.2867. That 7 number is basically the PIP. If, let's say USDJPY is at 117.23, that 3 is basically the PIP in that yen FX rate. If it's a euro yen and it's at 150.65 the 5 is the PIP on the euro yen. So let's focus on the euro-USD price first. Looking at the euro-USD the price moves from say 1.2853 to 1.2873, it's just gone up 20 PIPs. If it goes from 1.2853 down to say 1.2792, it's just gone down by 61 PIPs. PIPs provide an easy way to calculate the P&L. To turn that PIP movement into a P&L calculation, all you need to do is to basically take the size of the position. Say, for instance, you have 100,000 euro dollar position. The 20 PIP move equates to $200 because it's euros 100,000 times 20 PIPs, which is 0.0020, and that's $200. For a 50,000 euro dollar position, the 61 point move translates into $305 because that's 50,000 euros times 0.0061, that's equal to 305. Whether the amounts are positive or negative, that depends on whether you were long or short for each move. If you were short for the move, for the move higher, that's a minus in front of the $200. If you were long, it's a plus. So, let's say you want to calculate that for another currency. I mean, euro USD, which is what we considered earlier, that's easy to calculate, especially for US dollar based traders, because the P&L accrues in dollars. Let's say you're trading dollar CHF, Swizzie. Okay, and you've got basically another calculation to make before you can make sense of that. So that's because the P&L is going to be denominated in Swiss francs because CHF is the Swiss francs is the counter currency. If USD-CHF drops from 1.2267 to 1.2233, and you're short US dollars 100,000 for the move lower, you've just got caught 34 PIP decline. That's a profit worth CHF $340, because that's a $100,000 times 34 PIPs, which is 0.0034, that's equal to Swiss francs 340. Yeah, so it's Swiss francs 340, but how much is that in US dollars? To convert that into US dollars you need to divide the CHF 340 by the US dollar, Swiss franc rate. You typically use, you'd always use the closing rate of the trade which is 1.2233 because that's where the market was last. And you would get about US $277.94. Now things have changed, and they'll continue to change in the Forex market. Even the venerable PIP has now got updated as electronic trading continues to advance. Half the prices have been the norm in certain currency pairs in the the bank market for many years. Now, with online markets and catching up, we basically rapidly advancing to decimalizing PIPs, which is basically one-tenth of a PIP, we are now trading in one-tenths of PIPs. Now how do you factor in the profit and loss into the margin calculations? The good news is that most FX trading platforms calculate the P&L for you automatically. Both unrealized, while the trade is open and realized when the trade is closed. So I mean, then why do you need to essentially calculate the, or do the calculations for P&L using PIPS? Because brokerages only start calculating your P&L after you enter a trade. To structure your trade what you need to do is to manage your risks effectively, which is to understand how big a position do you want, how much margin to risk, and so on. And you're going to need to calculate your P&L, the outcomes, before you actually enter the trade. So understanding the P&L implications of a trade strategy you're considering is extremely critical to maintaining your margin balance and staying in control of your trading. Now the simple P&L calculation can help prevent you from making costly mistakes like putting on a trade that's too large. And the minimum you need to calculate the price point at which your position will be liquidated when your margin balance falls below the required ratio. [MUSIC]