What Is a Forex Stop Out Level?
A Forex stop out is something that most traders fear the most! But what is it exactly? In this article, we will tell you the meaning of both a stop out and a stop out level in Forex trading, provide examples, explain the role of leverage and much more!
Table of Contents
Forex Stop Out: An Introduction
This happens when a trader's margin level falls to a specific percentage - known as the stop out level - meaning that they can no longer support their open positions. The level at which the stop out is enacted varies among brokers.
A stop out is not optional, it is an automatic process and, once initiated, it is not usually possible to prevent it from proceeding. So why would your broker do this?
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The Role of Leverage
Forex is a leveraged product, meaning that instead of a trader needing to pay for the entire cost of a market position, their broker can lend them a set amount of the capital.
For example, if you have access to leverage of 1:100, then you can open a position worth $100,000 with a deposit, or margin, of just $1,000.
Currency movements are, in reality, very small. Therefore, for this to yield decent potential returns, large sums of money are usually invested into each trade. The majority of traders do not have access to large amounts of capital to trade with and this is why leverage was designed. Leverage creates a ready pool of funds for Forex traders to finance their trades.
Leverage is far from perfect, and it does come with an unwanted effect. It is capable of not only magnifying potential profits, but also potential losses.
Any losses incurred are not taken from the leverage money, but directly from the trader's account. If losses get to a certain point where the trader's equity is almost wiped out, the broker will enact the stop out - automatically closing their positions, to secure the leverage money they provided earlier.
Understanding Stop Out Levels
If there are multiple active positions on a trader's account when the level is reached, it is normal for the broker to close out the least beneficial ones first and leave the profitable ones open. However, if all of the positions are losing, they will all be closed.
As mentioned above, the levels at which a stop out will be enacted will vary from broker to broker and, therefore, it is important to know what levels are used by your broker. A large amount of traders fail to check this, and just rush into opening their accounts.
Some brokers may state in their trading conditions that their margin call is the same as their Forex stop out level. The unpleasant implication of this can be that no warnings are given in advance of your positions being closed once you reach this level.
Other brokers will have a separate margin call level and stop out level. For example, let's say a broker has a stop out level of 10% and a margin call level of 20%. What this means is that when your equity gets to 20% of the used margin (which is the equity level necessary to sustain the position) the trader will then get an advance notice from the broker to take steps to prevent a stop out.
If nothing is done and your account equity drops to 10% of the used margin your positions will be closed automatically by the Forex broker. If you have such a broker, the margin call is not such a dreaded thing – it is a simple warning and with good risk management you will most likely prevent the level where your trades are closed from being reached. These brokers may suggest you deposit more money in order to meet the minimum margin requirement.
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Forex Stop Out: Level Examples
Let's look at a couple of examples to help further illustrate the concept.
Imagine that you have a trading account with a broker that has a 50% margin call level and a 20% stop out level. Your account balance is $10,000 and you open one trading position with a $1,000 margin.
If the market turns against you and the position loses $9,500, your account equity will drop to $500 ($10,000 - $ 9,500). This loss means that your equity has reached 50% of your used margin ($1,000), meaning that the broker will issue a margin call warning.
If you do nothing, and the market continues to move against you, when the loss on your position reaches $9,800, your account equity will be $200 ($10,000 - $9,800). In other words, your equity has fallen to 20% of the used margin and a stop out will be triggered automatically by your broker.
The last example is as follows: A Forex broker has a 200%/100% margin call and stop out level respectively. Your trading account balance is $1,500 and you open a trading position with a $200 margin.
If the market moves against you and the loss on this position reaches $1,100 - you will be left with an account equity of $400 ($1,500 - $1,100). Your equity is now 200% of your used margin ($200) and, therefore, a margin call will be initiated.
If you take no action and your loss on this position reaches $1,300, your account equity will drop to $200 ($1,500 - $1,300). Your account equity is now 100% of your used margin, meaning that your broker will execute the Forex stop out and close your trading position automatically.
How to Avoid a Stop Out in Forex Trading
If you want to avoid any troublesome outcomes, you need to take some steps to prevent stop outs. Generally, it is all about appropriate trade management, however, we do have some useful tips for you to follow. The first one is to stop yourself from opening too many positions in the market simultaneously. Why? Because more orders mean that more equity is used up to sustain a trade, so you leave less equity as free margin, in order to avoid margin call and the stop out level in Forex.
To keep chaos at bay, you are strongly advised to use stop-losses - which will allow you to control your losses. Furthermore, if your current trade is desperately unprofitable, you need to consider whether there is any sense in keeping it open. It would be a much better decision to close it while you still have some funds in your account, otherwise, your broker may have no alternative but to close the position for you.
You should also consider using hedging techniques. The problem is that a lot of Forex traders don't know anything about hedging at all. Frankly speaking, you can not survive in the Forex market without adopting a technique that professional traders use in an attempt to cover for their losses. It is an inevitable fact that everyone will lose money trading Forex at some point. You can, however, take steps to ensure that you do not lose more than you have to.
Earlier in the article we took a look at a situation in which you might be issued a margin call prior to your trades being closed automatically. If this is the case, you may choose to immediately add money to your trading account to avoid a forced closure of your positions. However, always remember that you should only trade with money that you could afford to lose.
This means that you have to manage money in a sensible manner (e.g. only use leverage if it seems rational for you to do so) - the most successful traders only trade about 2.5% to 5% of their equity. If you are new to Forex trading, you could benefit from more practice. Using demo trading accounts can provide the opportunity to test your strategies until you feel that you can be profitable once again, after that, you can turn your attention to live trading.
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Mistakes are not always the best teachers and, when it comes to stop outs, it is better to prevent unpleasant experiences completely, if at all possible. It is important to know the significance of stop out levels in Forex and to understand that they can be easily prevented. All you need is wise account management and, of course, trading knowledge, combined with a good amount of trading experience.
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