Every business exists to be successful and aims to be profitable. In the world of trading and investments too, it is all about profits and losses. But for actual gains to be realised, the position has to be liquidated. Similarly, a loss can only be realised in the books when an open position involving a loss in a transaction is closed.
So what then of a profit or a loss in a trade that is still open? How is an open profit or a loss calculated and accounted for?
Let us take a look at the review of the concept of open profits and losses.
The Concept of Open Profit and Open Loss
When a trader or an investor first makes a purchase, he does so with the intent of making a profit. He has taken a position into the asset with an estimate as to how much it will increase to (if it is a buy) or decrease to (in case of a sell). This must be on the basis of his research and analysis that offers the potential of an upside in his investment.
Assuming that his trade works to plan and, in the case of a buy decision, the price of the asset increases, he would have made a gain. But this gain continues to be a notional profit till such time he makes an actual sale and exits the position he has taken.
Similarly, if he expected the price of an asset to fall and, therefore, he sells a certain number of units of the asset, his payoff here depends on the asset price to further decrease. But again, the actual profit he can make here too will be only when he closes his position.
Here is an example to elucidate the concept of open profit and open loss.
X buys a stock for the prevailing price of $100. If the stock price moves up to $110 and X continues to hold the stock, he would have had a gain of $10. This is just a notional increase in the value of the stock he owns and does not qualify for an actual profit. To book the profit, X has to liquidate his position and sell his stock. If he does that at $110 itself, he makes a profit of $10. But if he waited a little longer and saw the price drop to $105, the notional or the open profit of $10 just got reduced to an actual profit of $5.
The converse will be a possible drop of the price from $110 downwards. Sliding below the purchase cost of $100, if the price further drops to $95, X would have foregone his open profit of $10 and instead be looking at an open loss of $5. It is still not an actual loss unless he decides to exit the stock at a lower price to, maybe, reduce further erosion of his capital. If he waits a little longer and finds that the price drops further to $90 and he resolves to exit the position, his actual loss would stand at $10.
Here is an Illustration of an Open Profit and Loss of an Asset
The basic calculation of open profit and loss is quite simple. The change in the value of the asset over time – from acquisition to the current price – without effecting a sale and closure of the position taken is either a gain or a loss. This unrealised gain or loss is something that is notional and outside of the books.
Here is a step by step sequence of the calculation of the open profit or loss.
- List down the acquisition cost, the price at which a buy position was taken into the asset.
- Check the current price at which the asset is trading at.
- If the price sees an increase, this points to an unrealised profit or an open profit.
- If the price sees a drop, then the asset has an unrealised loss or an open loss.
- The total open profit or loss is the sum of the gain or loss per unit multiplied by the number of units held.
An analysis of the above process points to the market reality of asset prices being volatile and the chances of upward and downward movement. For the duration of the holding before the eventual liquidation of the trade, there will be either an unrealised gain or a loss.
When a comparative study is made of the results of such open profit or loss can help understand the asset and its potential to appreciate or the possibility of losing value.
The Purpose of an Open Profit and Loss
So why do you need to have an Open Profit and Loss at all? When it is an unrealised gain or loss, how is it even relevant to a trader? That is a valid question as the end result of every trade or investment is finally the profit or loss you reap.
But knowing just how well your decisions are coming along is important for you to periodically take stock of the potential outcomes of the trade or investment. Here are some of the reasons why having an open Profit and Loss and tracking it is useful.
Take quick and timely remedial measures:
In the absence of a periodic indicator of the performance of your trading decision, it is difficult to make an opportunistic move or a timely corrective measure.
An open Profit and Loss can be a good gauge to measure the wellbeing of your investment. The moment an extreme variance is sighted, it becomes possible to review the endgame and decide on liquidating the position.
Cross checking and re-evaluating your research and analysis:
This can be a good appraisal of your research material and analytical methods for an in-trade review. It can provide further insights on your information sources and help you tweak the resources you work with.
Doing such mid-point reviews can be useful opportunities of learning and understanding the market conditions and the behaviour of the asset itself.
That said the Open Profit and Loss is still an interim tool and should be used judiciously. It is not final and these are figures that can never feature in your balance sheet due to its unrealised nature. The real figures that matters are the actual profits and losses booked upon liquidation of a position.
The Open Profit and Loss’s Role in Trading
The way to approach an open profit or an open loss is to see it in the context of the moment. It is important to not just see it in isolation but as a result of the overall picture.
How is the market doing overall? Has there been any macro-level development that is shaking up the market, which, in turn, has impacted your asset’s price? Or has there been news specifically on the asset you have chosen?
As someone monitoring the open Profit and Loss of your trades or investments, make sure that the unrealised gains and losses do not upset your overall frame of mind and strategy. It does not take long for an open profit to turn into a loss or an open loss to convert into a profit.
Tax Implications on Open Profit and Loss
A profit, regardless of the asset class you have traded in, will attract taxation as per local laws. Also, a loss can be hurting and harm both the investor morale and his pocket.
For realised profits and losses, an investor has to comply with the rules of capital gains and losses. When a trade is liquidated with a profit made, capital gains have to be filed and paid. In case there is a loss in the transaction, it qualifies as a capital loss. In one year, if you have had trades with both profits and losses, it is possible to strategically balance them to reduce your tax burden. For this, the capital gains can be offset by capital losses. It is possible to use a capital loss against future capital gains as well.
But what about the tax implications on your unrealised profits and losses? Does having an open profit or loss invite the taxman’s attention? Actually, it does not. The tax angle only comes into play for any profits or losses you actually incur. For trades that have not been closed and positions liquidated, any open profit or loss is not relevant from a taxation perspective.
An open stock position or a trade position that has not been liquidated will either see an appreciation or a reduction in the value of an asset that has been purchased. A gain or a loss that a trader sees in his investment remains only on paper till such time he holds on to the position. This is the open profit and loss or the unrealised gain or loss that remains only notional. Once the position is closed and exited from, such profit or loss becomes real.
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