Paper Profit
A paper profit (or unrealized gain) is the positive difference between the current market value of a held position and its original cost basis, representing potential profit that exists on paper but has not been converted to cash through the actual sale of the position. It becomes a realized profit only upon execution of the closing trade.
Key takeaways
- Paper profits are unrealized and can evaporate if the market moves adversely before the position is closed.
- Tax treatment differs: paper profits are generally not taxable until realized in most jurisdictions, creating deferral benefits.
- Mark-to-market accounting (required for hedge fund NAV and bank trading books) records paper profits as income for reporting purposes.
- Disposition effect — the behavioral tendency to realize winners too early and hold losers too long — is directly related to how investors psychologically treat paper profits.
- Scale trading strategies systematically convert paper profits into realized profits by selling portions of winning positions at predetermined price targets.
Explanation
Paper profit — the unrealized gain on an open position — is one of the most psychologically significant quantities in trading and investment management. Unlike realized profits, which represent certain cash in hand, paper profits are contingent: they exist as long as the market price of the held asset remains above the cost of acquisition. Market moves between the current moment and whenever the position is ultimately sold determine whether paper profits materialize as real returns or evaporate.
From an accounting perspective, the treatment of paper profits depends on the classification of the underlying position. Mark-to-market accounting — required for trading book positions at banks and hedge fund NAV calculations — records unrealized gains and losses as income and expense in the current period, making paper profits economically real for reporting and performance measurement purposes even before realization. This ensures that reported returns reflect current economic value rather than only realized transactions. In contrast, hold-to-maturity accounting (used for some bank portfolios) defers recognition until realization or impairment.
The disposition effect — extensively documented in behavioral finance research by Shefrin and Statman (1985), and empirically confirmed by Odean (1998) — describes investors' systematic tendency to sell winning positions (converting paper profits to realized gains) too early while holding losing positions (deferring paper losses) too long. This behavior is driven by prospect theory: investors are loss-averse and derive more pain from realizing losses than equivalent pleasure from realizing gains. As a result, they sell winners prematurely (to 'lock in' the paper profit and avoid the possibility it disappears) and hold losers in hope of recovery (avoiding the psychological pain of recognizing a loss).
For scale trading strategies — a systematic approach to managing positions in trending markets — paper profits are the mechanism by which gains are locked in through incremental sales at rising price levels. Rather than holding an entire position until an arbitrary exit point, the scale trader sells a fixed fraction of the position at each pre-set price target (e.g., sell 20% at +5%, another 20% at +10%, etc.), systematically converting paper profits into realized profits while maintaining exposure to further upside through the remaining position.
In the context of pips — the smallest price increment in forex trading — paper profits are tracked in pip terms throughout the trade's life. A long EUR/USD position with an entry at 1.0800 that has moved to 1.0900 carries a paper profit of 100 pips. The pip value (determined by the lot size and the base currency) converts this paper profit in pips into a dollar amount, which fluctuates until the position is closed.
Formula
Paper Profit = (Current Market Price − Cost Basis) × Number of Units; Unrealized P&L % = (Paper Profit / Cost Basis) × 100%
Example
A hedge fund established a long position in 10,000 shares of a pharmaceutical company at an average cost of $45 per share ($450,000 total cost basis) six months ago. The company's drug trial results were positive and the stock now trades at $72 per share. The fund's paper profit is ($72 − $45) × 10,000 = $270,000 — a 60% gain on cost basis. The fund's monthly NAV calculation marks this position to market, reporting the $270,000 unrealized gain as part of the month-end performance. The general partner accrues a performance fee on the paper profit (though it is only paid upon crystallization). If the stock subsequently declines to $60 before the fund closes the position, only $150,000 of the paper profit is realized — the remaining $120,000 evaporated, illustrating why paper profits must be distinguished from realized economic gains.
Related terms
Basis Behavioral Finance Counter Trend Trading Crystallization Disposition Effect General Partner Give Up Hedge Fund Implicit Transaction Costs Lot Size Mark To Market Nav Calculation