Each day of trading brings day traders a new challenge of ending the day profitably. Day traders like to boast about their profits, but two different types of profit actually exist, and the difference between them can be the contrast between numbers on paper or real, cold hard cash in the bank. You might see terms such as "realized P/L" or "unrealized P/L"—where "P/L" means "profit or loss"—used to describe these two types of profit.
- Realized profit is profit that comes from a completed trade—in other words, a trade that has been exited.
- Unrealized profit, sometimes called "paper profit," is profit that comes from a currently active trade, such as a trade that has not yet been exited.
- The difference between realized and unrealized profit may appear slight, but it can mean the difference between a profitable trade or a losing trade.
- When you exit a trade and take your realized profit, this money is considered income by the IRS, and you'll need to pay taxes on it.
Realized profit is profit that comes from a completed trade, in other words, a trade that has been exited. Realized profit is usually already deposited into the trader's trading account and can be withdrawn from their trading account to a bank account.
Realized profit is included in the account balance in trading account statements. To keep track of each day's trading success, it is often shown on trading software as a daily profit that is reset to zero at the beginning of each trading day.
Unrealized or Paper Profit
Unrealized profit, sometimes called "paper profit" (or "paper loss" if negative), is profit that comes from a currently active trade, such as a trade that has not yet been exited. It is the amount of profit you would take if the trade was exited at that time. Unrealized profit will change with each price change, so it can be reduced to zero or become an unrealized loss at any time.
Unrealized profit becomes realized profit at the moment that a trade is exited.
A Few Examples
As an example of realized profits, say you own 500 shares of stock in Acme Widgets Co., and you receive a cash dividend of $0.25 cents per share. This means you have a realized profit of $125 (500 * $.25) from your stock investment. This profit has been realized because you actually received cash, and even if the stock price changes, it doesn't affect your cash profit.
Additionally, say you bought your Acme Widgets shares at $15 each, and you turned around and sold them in two years for $20 each. You would realize a profit, or a gain on your investment, of $5 per share.
If you instead were to wait to sell, anticipating that the price might still go up, you would only have a paper profit of $5 per share. The market could go up or down, and your profit could grow or vanish in an instant.
As long as you hold the shares without selling them, you run the risk of losing some or all of the profit on your shares, as well as your principal. At tax time, you won’t need to claim this paper profit on your return as income, because you have not yet realized it by taking the money in cash. You could defer taxable income for many years if you choose to hold on to stocks or other investments rather than sell them and realize any profits.
The Only Real Kind of Profit
When traders talk about their profit, they are referring to their realized profit. However, if they say something like "A trade is X ticks in profit," they are referring to unrealized profit from a trade that they are currently holding.
The difference between realized and unrealized profit may appear slight, but it can mean the difference between a profitable trade or a losing trade. Unrealized profit is theoretical profit that is currently available, but could be taken away again at any moment when the price moves against the trade.
Realized profit is real profit that can no longer be affected by price changes because it is no longer part of an active trade. It's real money that can be deposited into your bank account.
Taxes and Realized Income
When you exit a trade and take your realized profit, this money is considered income to you by the Internal Revenue Service (IRS). In other words, as soon as you take a realized profit, you'll owe income taxes on it because it's real money to you, not just paper profit.
If you're an investor, you need to show the trade's gain or loss on IRS Form 8949 and list the detail of your trades on IRS Schedule D. If you happen to trade very actively, you can qualify as an individual with a trading business. In that case, you'd get the opportunity to write off your office and other business expenses to offset against your trading income.
Check with a qualified CPA to find out what the IRS considers an "active" day trader for business purposes.