Understanding Forex stop outs and stop out levels is crucial for any trader looking to navigate the volatile waters of the foreign exchange market successfully. This comprehensive guide delves into the intricacies of Forex stop outs, the role of leverage, how stop out levels are calculated, and effective strategies to avoid such scenarios. By the end of this article, you will have a clear understanding of how to manage your trades effectively and minimize risks associated with Forex trading.
Forex Stop Out: An Introduction
A Forex stop out is something that most traders fear the most! But what is it exactly? In this article, we will explain 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.
Forex Stop Out: An Introduction
A Forex stop out is when all of a trader's active positions in the foreign exchange market are automatically closed by their broker. 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?
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.
However, leverage is a double-edged sword. It is capable of magnifying potential profits, but it also magnifies potential losses. Any losses incurred are not taken from the leverage money but directly from the trader's account. If losses reach a 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 positions are losing, they will all be closed.
The levels at which a stop out will be enacted vary among brokers, so it is crucial to know what levels your broker uses. Many traders fail to check this and 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 have separate margin call levels and stop out levels. For example, let's say a broker has a stop out level of 10% and a margin call level of 20%. This means that when your equity gets to 20% of the used margin (the equity level necessary to sustain the position), the broker will give you an advance notice 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 a dreaded thing—it is a simple warning. With good risk management, you can most likely prevent reaching the level where your trades are closed. These brokers may suggest you deposit more money to meet the minimum margin requirement.
Forex Stop Out Level Examples
Example 1:
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), so 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). Your equity has fallen to 20% of the used margin, and a stop out will be triggered automatically by your broker.
Example 2:
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), so 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 steps to prevent stop outs. Generally, it is all about appropriate trade management. Here are some useful tips to follow:
Avoid Opening Too Many Positions: More orders mean that more equity is used to sustain a trade, leaving less equity as free margin to avoid margin calls and stop out levels.
Use Stop-Losses: Implement stop-losses to control your losses and prevent your account from reaching the stop out level.
Close Unprofitable Trades: If a trade is desperately unprofitable, consider closing it while you still have some funds in your account, rather than risking a stop out.
Use Hedging Techniques: Hedging can help cover potential losses. Many professional traders use hedging to manage their risk.
Add Funds When Necessary: If you receive a margin call, consider adding funds to your account to avoid a forced closure of your positions. However, only trade with money you can afford to lose.
Sensible Money Management: The most successful traders only trade about 0.5% to 3% of their equity. Using demo accounts to practise strategies until you feel confident can also be beneficial.
Conclusion
Mistakes are not always the best teachers, and when it comes to stop outs, it is better to prevent unpleasant experiences if possible. It is important to know the significance of stop out levels in Forex and to understand that they can be easily prevented with wise account management, trading knowledge, and experience.
FAQs
What is a Forex Stop Out?
A Forex stop out occurs when a trader's active positions are automatically closed by their broker due to the margin level falling to a predetermined percentage, known as the stop out level.
How Does Leverage Affect Stop Outs?
Leverage magnifies both potential profits and losses. If losses deplete a trader's equity, it can trigger a stop out to secure the leverage money provided by the broker.
How Can I Avoid a Forex Stop Out?
Avoiding a stop out involves effective risk management, such as using stop-loss orders, closing unprofitable trades early, and maintaining a sensible number of open positions.
What Happens During a Margin Call?
During a margin call, a trader is notified to deposit more funds or close positions to meet the minimum margin requirement. If unheeded, it can lead to a stop out.
Are Stop Out Levels the Same for All Brokers?
No, stop out levels vary among brokers. It is crucial for traders to understand their broker's specific stop out and margin call levels.
What Are the Risks of High Leverage in Forex Trading?
High leverage increases both potential profits and losses. Traders using high leverage risk rapid equity depletion, which can trigger margin calls and stop outs.