When choosing aForex broker andplanning toopen your first account, you will probably hear alot about stop-out level, margin call, andleverage. While many brokers will only talk about margin calls, others seem todelineate a clear border between margin calls andstop-out levels. What is astop-out level, andwhat is thedifference between astop-out level andamargin call?
Tostart with, let’s quickly review thedefinition ofmargin. For many people, trading onmargin is one ofthebiggest motives totrade Forex. With Forex, you do not actually need $100,000 totrade $100,000 worth ofcurrency. You might need, forexample, only $1,000 if your broker offers you leverage of1:100. This means that forevery dollar you put down inyour deposit, you are allowed totrade $100 worth ofcurrency. This is referred toastrading onmargin. It is incredibly powerful andcan make you rich overnight— ordestroy you overnight, which is considerably more likely!
You can rephrase the1:100 leverage above as1% margin. This means that thebroker requires you topresent 1% ofthetrade asaminimum security margin.
Crucial to understanding of when a margin call or a stop-out may be issued on your account is the concept of a margin level. A margin level is your account's equity divided by your account's used margin:
Now when you join aForex broker, you will read about their margin call andstop-out procedures, andyou will usually see some percentages, which refer toyour equity. Forexample, abroker may list amargin call at20% andastop-out level at10%. What this translates tois that if during thecourse ofatrade, your account equity drops to20% ofthemargin that you are required tomaintain inyour account, you will get amargin call. Inthecase ofthis kind ofbroker, this will usually be nothing more than awarning andastrongly worded suggestion that you close some orall ofyour trades, ordeposit more money tomeet theminimum margin requirement. If you do these things andall is well, you are safe fornow (but really should close out your trades assoon aspossible andreturn to a demo account). If ontheother hand you do not, andyou stay inthetrades, andthey go further against you, your equity may drop to10% ofwhat is required, atwhich point you will hit thestop-out level. Atthis point, your trades will be closed automatically byyour broker starting attheones that are failing most badly. If necessary, all ofyour trades will be shut down inorder tomeet theminimum margin requirement.
Another way ofdoing things is amargin call at100%. That means once your equity drops below 100% oftheminimum requirement totrade, you will not only get amargin call, but your trades will be closed out just like atastop-out level. This combined system contains no warning— it simply closes your trades.
How do you avoid this horrible thing happening toyou? Toavoid getting amargin call and/orhitting astop-out level, you should only trade what you can afford. Manage your money inarational manner; only use leverage if it makes sense foryou todo so. Just because it is there does not mean you have touse it! Alot ofprofitable traders— most actually— only trade about 2.5–5% oftheir own equity. There is nothing wrong with doing it this way— you are more likely tomake it inthelong run. Andif you do hit astop-out level orget amargin call? Go back todemo testing until you can trade profitably again, andthen get back tolive trading when you are truly ready.
Some Real Life Examples
Example 1. You have anaccount with abroker that has 50% margin call level and20% stop-out level. Your balance is $10,000, andyou open atrading position with $1,000 margin. If theloss ontheposition reaches $9,500, your account equity becomes $10,000— $9,500 = $500, which is 50% ofyour used margin, thebroker will issue amargin call warning. When your loss ontheposition reaches $9,800, andyour account equity becomes $10,000— $9,800 = $200, which is 20% oftheused margin, thestop-out level will be triggered, andthebroker will automatically close your losing position.
Example 2. Abroker has 200%/100% margin call andstop-out levels. Your balance with it is $1,500. You open atrading position with $200 margin. If theloss onthis position gets to$1,100, your account equity becomes $1,500— $1,100 = $400, which is 200% ofyour used margin, then amargin call will be issued. When your loss onthat position reaches atleast $1,300, andyour account equity becomes $1,500— $1,300 = $200, which is 100% oftheused margin, your position will be closed automatically bya stop-out.
Example 3. You have a $5,000 account at a broker with 150%/100% margin call and stop-out levels. You open a trade using $1,000 margin. You would get a margin call when your loss on that trade reaches $3,500 (so your equity is $1,500 or 150% of your $1,000 used margin). You would get stopped out when your loss reaches $4,000 (so your equity is $1,000 or 100% of the $1,000 used margin). However, if you opened a bigger trade, using your whole account size ($5,000) as margin, you would get a margin call immediately, and since stop-out is 100%, you will not be even able to open that position, or otherwise, it would get closed out instantly, since you have to maintain at least $5,000 equity in your account.
Three Important Notes
- The amount of used margin for position maintenance does not depend on the stop-out level. It only depends on the trade size, leverage, and the broker's margin requirements. For normal Forex trades, it is usually just the trade size divided by the leverage. For example, 0.1 lot on EUR/USD at 1.1000 with 1:100 leverage will require 0.1 × 100000 × 1.1000 ÷ 100 = $110 margin.
- The margin call and stop-out mechanisms do not completely prevent the possibility of an account balance becoming negative due to the losses on open trading positions. In rare cases, it is possible for such a situation (when account balance goes below zero) to appear in Forex. A notable example is January 15, 2015, Swiss franc gap that resulted in EUR/CHF positions closing hundreds pips below the stop-losses and stop-outs failing miserably. However, normally, brokers only seek redemption on very large negative balances as it is quite difficult for them to make the account holder compensate the loss.
- It is important to remember that margin call and stop-out levels are defined in relation to margin and equity, not to loss and equity. So, it is impossible to tell the exact loss level when any of those levels will trigger without knowing both the amount of used margin and the equity of your account.
