It is well known that the stock market experiences periods of unforeseeable, and sometimes sharp, price movements.
And if you’re owning stocks during such volatile periods, the fair market value of your portfolio could change drastically before you sell the stocks.
Until you sell, your profit or loss is just on paper since you’ve not locked it in by offloading the stocks in your portfolio. At this point, any change in value since you bought the stock is referred to as unrealized gain or unrealized loss.
Read on to learn the meaning of realized and unrealized gains and losses, and how they impact your portfolio.
What are realized gains and losses?
In the stock trading world, a realized gain is the actual gain/profit that occurs as a result of selling a stock.
Simply put, realized gains are profits arising from completed transactions. These gains have been converted into cash. To realize gains from a stock you own, you have to receive cash and not watch its value go up without selling.
Realized gains are usually reported as taxable income and a stock trader may decide to delay selling shares if he knows there will be a huge associated tax burden.
On the other hand, a realized loss is the loss that occurs when a stock is sold for a price lower than the initial buying price.
On the other hand, a realized loss is the loss that occurs when a stock is sold for a price lower than the initial buying price. A trader may sell some of the stocks in his portfolio for which there will be a realized loss.
By doing so, the realized loss offsets the realized gains, resulting in reduced or zero tax.
Realized gain formula
Since realized gains is the profit earned by selling a stock or another security at a higher price than the price it was initially bought, the formula is as shown below:
Realized gain = Selling price of a stock – Initial purchase price of the stock
Realized loss formula
As for realized loss, the formula is as follows:
Realized loss = Initial purchase price of the stock – Selling price of the stock
Example of a realized gain
Let’s say you buy 100 shares in Apple (NASDAQ: AAPL) at $150 per share. Shortly afterward, the price of the stock rises to $180 per share and you then sell all your shares.
At this point, you have a realized gain on this stock of $30 per share since the value of your shares is $30 higher than when you first entered into the position.
Realized gain: $180-150 = $30
Total realized gain from the transaction is $30×100 shares = $300
Example of a realized loss
Now, let’s say you bought 100 Apple shares for $150 each. The company’s fortune then shifts and the price of the stock drops to $110 per share and you sell all your shares.
Since you have sold the stock, you would now have a realized loss of $40 per share ($40 below where you first got in).
Realized loss: $150-$110 = $40
Total realized loss from the transaction is $40×100 shares = $400
What are unrealized gains and losses?
When you buy a stock, the value of the stock may change several times before it is sold. By the time you sell the stock, the profit or loss on the stock is just on paper because you have not cashed them.
Therefore, at the time of the valuation, the change in the price of the stock from the time it was bought is called unrealized gain or loss.
An unrealized gain refers to the increase in the paper value of securities such as stocks, which have not yet been sold by the holder.
Unrealized gains are also known as “paper profits.” Think of it as money on paper, which the stockholder expects by selling the stock sometime in the future.
Generally, stock traders hold onto unrealized profits when they believe that the value of a stock will continue to increase.
Some may also decide to cling to a stock whose value has gone up because they want to avoid paying capital gains tax immediately, in case the tax figure will reduce if they wait.
Unrealized gains are not taxable, so if the price of your stock goes up but you don’t sell it, this will not affect your taxes.
An unrealized loss occurs when the price of a stock falls after you have bought it but you are to sell it. Unrealized losses are also referred to as “paper losses.” If you sell that stock, it becomes a realized loss.
If you are holding a stock that has lost value and you don’t want to offload it immediately, then it would be a good idea to wait and see if the price will go up again.
That said, sometimes your best option is to get rid of a losing stock in order to minimize your losses and reduce taxes owed. A capital gain can be used to offset a capital loss for tax purposes.
For example, if you realize $1,000 in capital gains in a particular tax year and you also incur an $800 capital loss, then you’re only going to owe taxes on $200 in gains.
Calculating unrealized gains and losses
Calculating unrealized gains and losses is quite simple. To do this, you need to first subtract the initial purchase price of your stock from its current market price. Then, multiply the difference by the total shares you own in the stock to get unrealized gain or loss.
If the difference is higher than the initial purchase price, the value of the stock has increased and you have an unrealized gain. But if the difference is less than the initial purchase price, the value of the stock has dropped and you now have an unrealized loss.
Example of an unrealized gain
Suppose you buy 100 Apple shares at $150 per share, and an hour later, the price rises to $170 a share. If you were to sell these shares, you would stand to make a profit of $2,000.
But if you decide not to sell them, you would not make any profit. Instead, you would have an unrealized gain or “paper” profit of $2,000.
Example of an unrealized loss
Now, let’s take a look at the following example of an unrealized loss.
Let’s say you buy 100 Apple shares at $150 per share, and after thirty minutes, the price drops to $120 a share. If you choose to sell the shares, you would record a realized loss of $3,000.
However, if you didn’t sell them, you would just have an unrealized loss of $3,000.
When buying and selling financial instruments for a profit, day traders and investors need to understand the difference between realized and unrealized gains and losses.
Realizing a gain or loss will have tax implications and will need to be reported to the IRS.
For more reading on a similar subject, check out our post on Tax Loss Harvesting.