Understanding Profit and Loss (PnL) in Cryptocurrency Trading

For those familiar with traditional finance, the concept of Profit and Loss (PnL) is not new. However, how does PnL apply in the world of cryptocurrencies? Grasping terms like Mark-to-Market (MTM), Realized PnL, and Unrealized PnL can significantly enhance one's understanding of their cryptocurrency holdings.

Without a well-defined process for tracking gains or losses, cryptocurrency trading can become overwhelming, and traders may struggle to make informed decisions. PnL reflects the change in value of a trader's positions over a specific period.

Fundamental Concepts of PnL in Crypto

In the cryptocurrency sphere, PnL refers to the calculation of profit or loss derived from an investment or trading position. It serves as a crucial metric for evaluating the financial performance of a trader or investor in the digital asset market.

Let's explore some key terms in PnL terminology:

Mark-to-Market (MTM)

MTM is the process of valuing an asset based on its current market price or fair value. In cryptocurrency trading, if an investor holds a certain amount of Bitcoin (BTC), its value will fluctuate according to the current market price.

The general formula for calculating PnL is:

PnL = Current MTM Price - Previous MTM Price

For instance, if the MTM price of Ethereum (ETH) today is $1,970, while yesterday's MTM price was $1,950, the PnL would be $20, indicating a gain. Conversely, if yesterday's MTM price for ETH was $1,980, it would indicate a loss of $10.

Future Value

Future value represents the projected worth of a digital currency at a future point in time.

For example, if a trader stakes $1,000 worth of a cryptocurrency with an annual reward of 4%, how much will they recover after a year? The answer is $1,040. At the time of staking, the present value is $1,000, while the future value is $1,040.

There's always a present value at the time of staking, but when considering the future as a whole, there could be countless future values.

Realized PnL

Realized PnL is calculated after traders have closed their position (sold their cryptocurrency holdings). It only takes into account the executed price of orders and has no direct relation to the mark price.

The formula for Realized PnL is:

Realized PnL = Closing Price - Opening Price

To illustrate, if the entry price for buying a certain amount of a cryptocurrency is $70 and the exit price is $105, the PnL for the period is $35, reflecting a gain. However, if the closing price of the trade was $55, the PnL would be -$15, indicating a loss.

Unrealized PnL

Unrealized PnL refers to the gain or loss currently held in open positions but not yet realized by closing the position. The formula to determine Unrealized PnL is:

Unrealized PnL = Current Market Price - Average Entry Price

For instance, if a trader has bought cryptocurrency contracts with an average entry price of $1,900, and the current market price is $1,600, the Unrealized PnL would be -$300.

Methods for Calculating PnL

To determine PnL in cryptocurrencies, a trader needs to find the difference between the initial cost of acquiring a digital coin and its current market value. Several methods for calculating PnL in cryptocurrencies include:

First In, First Out (FIFO) Method

The FIFO method requires using the asset's price from when it was first purchased. Here's how to calculate PnL using the FIFO method:

1. Calculate the initial cost of the cryptocurrency by multiplying the purchase price per unit by the number of units sold.
2. Determine the current market value of the disposed asset by multiplying the current market price per unit by the number of units sold.
3. Find the PnL by subtracting the initial cost from the current market value.

Last In, First Out (LIFO) Method

The LIFO method requires using the most recent purchase price of an asset in the calculation. Other aspects are similar to the FIFO method.

Weighted Average Cost Method

The weighted average cost method requires traders to determine the average cost of all units of a digital coin in their portfolio to arrive at the initial cost.

Open and Closed Position Gains/Losses

Analyzing open and closed positions at regular intervals is an effective way to monitor performance. An initial purchase in the market is an open position, while selling the cryptocurrency is called closing the position.

Year-to-Date (YTD) Calculation

YTD is a way to measure the performance of cryptocurrency investments from the beginning of the year to the current date. Investors who regularly buy and hold cryptocurrencies over years can know their unrealized gains with a year-to-date calculation.

Transaction-Based Calculation

A transaction-based calculation requires calculating the PnL for each specific transaction. This method is ideal when the number of transactions is small and a trader needs to calculate the PnL for these transactions separately.

Percentage Profit

The percentage profit method reflects the PnL as a percentage of the initial cost. To arrive at the profit percentage, divide the PnL by the purchase price and multiply the amount by 100.

Calculating PnL for Perpetual Contracts

Perpetual contracts are a type of futures contract without a settlement date or fixed expiry date. When calculating PnL for perpetual contracts in cryptocurrencies, traders must calculate both realized and unrealized PnL and then add them together to determine the total PnL.

PnL Calculations and Associated Tools

Understanding crypto PnL helps individuals know whether their cryptocurrency portfolio is generating profits or losses. Gaining insight into key parameters such as cost basis, quantity, price of each trade, and portfolio profitability helps traders evaluate the efficiency of their strategies and make necessary adjustments.

In addition to PnL calculations, tools like specialized spreadsheets and automated trading bots can help traders analyze their performance and focus on profitable trading opportunities, regardless of their experience level.