Notebook of a Share Trader

Profit and Loss -Realised vs. Unrealised

Traders deal with two different type of profit and loss when they speak of profits and losses made in the markets. Realized returns, often referred to as “booked”, are those which come about as the result of a position which has been closed out. The transaction has been cleared out.

Unrealized, or “on paper” gains and losses are those which involve open positions. You have your position open in profit or in loss.  An example of a unrealised return would be when one buys a stock at Rs.1000 and it rises to Rs.1100, but the trade remains open. In this case the trader has an unrealized profit of Rs. 100. When the trade would be closed out at that price, that Rs.100 profit would become a realized profit.

The concept of realised vs. unrealised returns is an important one in the trading and money management. Arguments are often had as to whether paper losses are real, or whether they only become real when actualized. Intra-day trader have clear escape from the margin money, as he square up his position at the end of the day. But particularly ‘day trader’ and investor has to maintain his cash reserve to support his position.

Not knowing how to get out of a losing trade or profitable trade. It’s amazing that most of the traders don’t have any clear escape plan for getting out of a trade. No matter how much the market moves either in favour or against a trader’s open position. The unrealised profit can be turned into loss and unrealised loss can be turned into profit. Traders generally tend to take the profit, if the losing trade into profit. But in case profitable trade turns into loss, it is very difficult to get out of the trade.

Spending profits before you realised them. This can cause major problems however, because this type of trade puts you in a highly euphoric state and leads to daydreaming about the huge profits still to come. The real problem occurs as you get caught up in the daydream and expectations. This causes you to not be prepared to get out as the market reverses and wipes off all your profits because you have convinced yourself of the eventual outcome and will deny the reality of the situation.

It is not good idea to remain invested in the market all the time. If the day trader or the investor has open position in the market, and market falls, either he has to stop losses and quit the market or he could have Plan B to double up his  position buying some more shares (if he has stop-loss at much lower price). The buying power of trader goes very low and his/her sentiment gets weak for further buy as he had already a losing position.

Imagine, a future trader has Rs.50,000 in his account and he buys 50 Nifty and pay the margin of Rs.25,000. The trader would still have Rs.25,000 available to enter new positions. This only changes when the Nifty future are sold and the profit or loss realised. Every point of Nifty is equivalent to Rs. 50 in this trade and if Nifty move 200 points above the bought price, there will be addition of Rs. 10,000 as unrealised profit in the account. So, the trader would have Rs. 35,000 free to use as margin. But, in case the Nifty is down by 200 points below the bought price, there would be deduction of Rs.10,000 as unrealised loss from the account and only Rs.15,000 would be free to use as margin.

Understanding the impact of realized and unrealized returns is something key in the development of both money management and trading. Failure to understand how these differences play the game with trader’s account can lead to major errors in the assumptions exposure. It can be the differentiate between a good system and a useless one, or between a safe risk profile and a risky profile.

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