What is Margin call and stop out on Forex. How to calculate margin level equity in forex. | Litefinance (2024)

What is stop out and margin call? How to calculate the margin level in forex

Definition of Margin Call and Stop Out. What does it mean and how to use it in trading. Practical examples of calculating. A model of risk-management to forecast the Margin level.

Margin Call and Stop Out are the standard trading conditions that must be specified in the account general information provided by forex brokers.

A margin call notification is sent by the broker about the necessity to top up your trading account. A margin call is like a risk warning, it occurs when there is not sufficient amount of money on your trading account to open trades. This is also when your floating losses are greater than the minimum margin requirement to hold your positions open.

A stop out is a signal that all active positions in the forex market will be closed automatically by the broker as your margin levels are too low to sustain the open positions. The level value (expressed in %) is specified by each broker in the agreement and may vary.

Control of the equity level on the trading account is one of the obligatory rules of risk management and must be suggested by any trading plan. To optimize the process, advanced traders often develop models allowing to estimate the level of maximum acceptable drawdown with the given leverage amount and position volume and not let it approach margin call and stop out levels. From this overview, you will learn how to develop such models, how to calculate the account equity level and how to manage the financial leverage.

Margin Call and Stop out: definition and the rules of calculation

Trading terminology is the first thing a trader should get acquainted with before trying themselves in Forex. Without it, it is impossible to make profits in forex, or even gust to communicate with your broker. Most newbie traders for some reason believe that it is enough to download a trading strategy from the Internet, to do everything exactly according to the recommendation on a demo account and you can begin to make cash fast and easy.

The buttons like “I have read, understand and agree with the Terms and Conditions” are clicked on without reading. Traders just ignore such a thing as Offer, all the terms of trading for each type of account are specified. This may eventually result in losing the deposit and misunderstanding between they trader and the forex broker. Today, I will explain two important trading terms, Margin Call and Stop Out, the levels of which are always specified by brokers in the trading conditions for an account.

From this article, you will learn the following things:

1. What is Margin Call and Stop Out, explained on practical examples of calculation
2. How to develop a model allowing to control the level of acceptable quotes and how to employ it in trading
3. How to avoid liquidating your positions by Stop Out

Margin Call and Stop Out: How to protect yourself from losing your deposit suddenly

So did this story happen on December 30, 2015. It was just ahead the New Year, the time when miracles occur and everybody wants to make new magic wishes. A private trader Denis Gromov also must have hoped for a miracle. Otherwise, it is hard to explain how he, starting the day with 5.6 million rubles managed to managed over 4.5 hours to carry out more than 5000 transactions buying and selling foreign currency totaling 42 billion rubles. Later, the 38-year-old trader said that he hadn’t understand what happened. Since the dollar was rising and so, Gromov thought it was an excellent opportunity to buy low and then sell high, and make money on it.

The trader traded a specific asset USDRUB_TOM. The Russian Central Bank uses USDRUB_TOM to set the official exchange rate of the USD for tomorrow (TOM means tomorrow). The exchange also traded USDRUB_TOD which settles on the same day (TOD – today). Gromov noticed that the dollar with next day settlement (USDRUB_TOM) is a bit more expensive than the dollar with today (USDRUB_TOD) settlement. In 38 minutes, he had more than 2,500 transactions, buying dollars with "today" settlements and selling with "tomorrow" settlements. The available collateral seemed to be insufficient, so he decided to use the financial leverage, provided by the broker. Total position on the two instruments did not go beyond the margin level (the amount of the deposit that is blocked by the exchange as a collateral for the transactions), but the turnover was already 23.7 billion rubles.

At that moment, the manager of the broker called and reported the so-called Margin Call. He offered to reduce the amount of borrowed funds and "to sell in reverse" until the account met the forex margin requirement. The trader’s mistake was simple, he didn’t take into account the cost of arbitrage trading (buying a security in one market and simultaneously selling it in another market at a higher price, profiting from the temporary difference in prices). Leverage allows you to increase the volume of your position, when rolling an opened position from one day to the next, a broker charges a fee (swap). The transactions with USDRUB_TOD were settled on December 31, and the ones with USDRUB_TOM were to occur only on January 11. Thus, there was swap charged for all these days off. That is on what the manager informed the newbie trader. He could do nothing but unwind all the positions with a loss.

The attempts to settle down the problem in court failed, but this story became a vivid example of what can be the results of misunderstanding of such terms as “margin trading”, “margin call” and “swap”.

What is margin trading and margin call

Forex margin trading is trading with financial leverage, provided by the broker. It allows the trader to open positions totaling a few dozen, hundreds, or thousands more than the trader’s own deposit, provided that the borrowed money will be paid off.

Different brokers offer different leverages, for example: 1:1 (i.e. no leverage), 1:10 (the trader can open positions with a volume 10 times higher than the own deposit), 1:100 or even 1:200. According to the recommendations of European regulators, previously, the maximum allowable leverage limit was 1:200, now it is 1:50, with the prospect of a decline to 1:30. However, these restrictions do not stop brokers with offshore registration and therefore leverages up to 1:1000 or 1:2000 can still occur.

Where does a broke take money to provide the so-called loan? None of the company representatives will answer you, citing a commercial secret. There may be a few sources:

• Assistance of the liquidity providers. Liquidity providers are investment banks whose liquidity is confirmed by the investors’ deposits. The brokers might share the spread. If this source was obvious, brokers wouldn’t conceal it, but the mechanism of providing the leverage is not revealed.
• Technical multiplier. Whatever leverage is presented, the trade is still conducted within the deposit of the trader. A trader who buys a currency, sooner or later sells it back, restoring the balance. Broker's leverage is only a digital instrument compensated with a reverse transaction. The total volume of transactions with such digital tools is many times more than the amount of real currency. But the system maintains a balance, as each trade in one direction is somehow followed by another trade in the opposite direction. The profit of one trader is the loss of others.
• Broker is a ‘kitchen’. Numbers are manipulated within the company itself. The broker aims at offering the trader as much leverage as possible so that the deposit is lost as quickly as possible.

In theory, it is often written that margin trading is a ‘virtual loan secured by the trader’s deposit’, or ‘bilateral transaction, where the trader who bought the asset for the loan money will be obliged to sell it’. In fact, this is not exactly so. In any credit transaction, the lender also faces the loan default risk. In margin trading, the broker does not bear these risks.

Example:

• Without leverage. A trader has $1,000, he wants to invest $600 in oil. Oil volatility is low — 0.1%-0.3% per day. Suppose that the trader is day trading and force majeure occurs in the oil market; oil depreciates by 5% at once, that is, from $60 to $57 per barrel. If the trader enterd a long trade with his $600, his losses would have amounted to 600 * 0.05 = $ 30. For a deposit of $1,000, the amount is small.
• With leverage. Suppose that the trader is confident in the oil price rise and decides to use the 1:1000 leverage. His principal amount of $ 600 is blocked by the broker as a collateral, while the remaining $400 of available funds will serve as a security. Investor opens a position in the total amount of 600 * 100 = $60,000. The force majeure breaks the investor’s plans and the loss of $ 30 turns into $3000. The trader doesn’t have that much money on the account, so all his active trades will be will be closed automatically by the broker before the oil price drops to $57. It is easy to calculate that a security deposit of $600 is able to withstand only 1% of the drawdown (60 cents) with such leverage, the remaining balance of funds ($ 400) - another 40 cents.

Margin call occurs when there are not enough funds in your trading account to open trades. This is also when your floating losses are greater than the minimum margin required. A margin call is a kind of warning that the trader’s deposit will soon go bankrupt with the current trend.

A Stop Out is when a trader’s margin level falls to a specific percentage (%) level in which one or all of the open positions are closed automatically (“liquidated”) by the broker. The positions are being closed until the equity level is again above the margin.

Example:

The broker sets margin call levels in forex at 20% and stop out is at 10%. The trader tops up the deposit with 300 USD and uses the leverage of 1:100, opening a position of 20,000 USD. The own funds, need to open such a position is 1/100 from 20 000, that is 200 USD. 20% of the margin amount is 40USD, 10 % is 20USD. This means that when the trader’s loss is 260 USD, there will be a warning, when the trader’s account is as little as 20 USD the positions will be opened forcefully.

The example is conditional, as it describes a simplified market situation. A more detailed calculation of the stop out level in Excel will be given below.

Important! European regulators, setting restrictions on maximum leverage, are not targeting brokers, rather, they are targeting the psychology of traders. The amount of leverage in the Forex does not involve any risk. After all, there is no difference whether a trader opens a $ 300 deal with a leverage of 1: 100 (the collateral is $ 200) or a leverage of 1: 200 ( the collateral is $ 100) when depositing $ 300. He will still trade within his deposit of $ 300. What matters is the volume of the position! If in this case it is targeted ($ 20,000), then in practice, emotions force traders to open larger positions with a big leverage, which can result in huge losses.

In MT4, the information on assets available and the margin level is specified in the bottom menu, in the Trade tab.

Interpretation:

• Balance. The deposit amount that the trader has topped up to the account.
• Equity. The current balance of the account after the trades executed. It is equal to the amount of the balance adjusted for current profit or loss. If the amount of loss on open losing trades exceeds the profit on profitable ones, in this box, the figure will be less than the Balance on the amount of loss. For example, $ 100 was deposited, for one of the two transactions, the profit was $ 32, for the second, there was a loss of $ 43. 100 + 32-43 = 89.
• Margin. (often referred to as a Collateral). It is the amount of the collateral to provide the opened positions, which is simply a portion of your funds that your forex broker sets aside from your account balance to keep your trade open and to ensure that you can cover the potential loss of the trade.
• Freemargin: Assets that are not involved in trading and can be used at the trader’s will. It is calculated like Equity – Margin.
• Margin level. The indicator of the account state, measured in percent. It is the main reference for the trader. If its value drops below the stop out level set by the broker, the closing of transactions will begin. It is calculated by the formula: "Equity" / "Margin" * 100%.

Example.

The trader deposits the account with $ 100 and is going to enter a trade with the volume of 0.01 lot at a price of 1.4500 using a leverage of 1: 100. 1 lot is 100,000 units of conditional currency, therefore for the purchase of 0.01 lots you need $ 14.5 (the volume of the whole position is $ 1,450). "Balance" is $ 100. "Equity", before the trade is entered, is also $ 100. "Margin" is $ 14.5. "Free Margin"is $ 85.5. “Margin level” - (100 / 14,5) * 100 = 689% .

How you can figure out a forecast based on margin level

Any theory is needed not only to be employed in practice, but also to be a basis for forecasts. The risk management system involves the development of a series of risk management models that would allow you within a few minutes to put down in the table the current changes, based on the present market situation, and see how the future result will change.

Managing the Margin level of the deposit enables you to predict at what quotes of the pair for a given lot volume a Forex stop out can occur. Knowing averaged volatility data, you can build an individual forex trading strategy of boosting (reducing) position size according to the price changing rate and in accordance with the level of leverage. The simplest version of such a table can be created in Excel.

Input parameters:

Fill in the table

Cost of minilots for current rate (D3) = C3*B3. Float loss before the first trade – 0, Margin is (F3) = D3/100 (100 in this case is the leverage amount. Margin level (Н3) = G3/F3. Switch the cell format into percentage points and you will get Margin level of 133%. It is far from stop out.

• Note.The example is conditional! According to traders opinions, you’d better not let the Margin Level to go below 700-500%. In thisexample, the main condition of risk management is not satisfied - 75% of the deposit is involved.

After the trade has been entered, the price suddenly reverses and goes 25 units down (1 unit is 0.0001 in reference currency). Fill in the second line B4 = 1,2475. Extend cells c and D downwards. Float loss: Е4 = D4-D3+E3. Extend cell F also downwards and past into the Gg4 cell the formula: =$G$3+E4. Extend the Margin level column downwards. As a result of the quotes drop, the Margin level has been 20% down. Fill in the table further and extend the formulas.

Gradually descending quotes wiped the account deposit, but the position has not yet been fixed, so, it is still too early to talk about a loss. The margin gradually decreases along with the value of the position, but it almost does not affect the Margin level. After the 7th line, the Margin level of the account reached a critical value of 13.5%. As you can see from the table, at a stop out level of 10%, the trades will be forcibly closed at a price between 1.2350 and 1.2345.

How should you apply utilize this table:

• Top up your account with 370 USD. The Margin level will be 10.04% at this quotes level. Another way is to top up the deposit so that the free margin will exceed the difference Equity - Margin (there isn’t any free margin in the seventh line before the stop out) and enter an opposite trade (locking), having created a separate table for it.
• Close5/6 of the position, leaving an opened position of 1 minilot. The loss will be $750 (900/6*5; line seven in the previous screenshot,corresponding to the margin level of 13.5%). Fix the loss in the table, and there is only left as much as $250 of the deposit and the current loss for the remaining position is $150. We adjust all the current formulas, based now on line eight with an updated amount of deposit and the position size, extending the cells.

It is possible that a position of two minillots could be left opened, I didn’t calculate this, but this table is designed for just such selections of numbers. Also, according to this table, it is convenient to calculate the size of the stop, adjusting it to the rate of the deposit. Such a template can be developed individually.

Special features of margin trading and the selection of the leverage in Forex

Special features of margin trading in Forex:

• Unlike other forms of borrowing, a trader isn’t charged an interest for using a loan in the common form. Each broker charges a swap – a fee for keeping a position open overnight that is accrued for all positions opened, including those that engage borrowed funds. The swap is subtracted from the trader’s own funds, thus speeding up the deposit decreasing.
• Margin trading is mostly suggested for short-term trading strategies. A trader uses a leverage only being fully convinced in the trend continuation. Having taken a profit on short-term trades, the traders returns to trading with only own funds.
• Trader's risks are in most cases limited by the deposit size.

Specification for the last paragraph. A broker offering its money within one day faces no risk, because with a sudden price reversal there will time to automatically close all trader’s positions. The situation is different with the transfer of the positions to the next day or in the case of a serious force majeure.

Example.

On January 15, 2015, the Swiss National Bank unexpectedly unpegged the franc exchange rate. Just in one night, the franc soared against the euro and the US dollar by 30%.

Few could expect such a decision. On the first day, due to high volatility, the trade terms and conditions were changed. Some companies suspended trading at all, others changed margin requirements. Hardly any broker could avoid losses, executing transactions in a low liquidity market; and the UK department of Alpari (UK) went bankrupt because of that situation. Official version is that due to exceptional volatility, the company ran out of liquidity. Clients’ losses exceeded their account equity. The losses that a client couldn’t cover was passed on to the company.

This situation is a vivid example that there are always exceptions to any rule.

How to avoid Margin Call and Stop Out:

• Carefully read the offer agreement, where the trade conditions are specified for each account type.
• Strictly follow the rules of risk management. The theory reads that the amount of the trades, entered at a time, mustn’t exceed 10% (in rare cases 15%) of the deposit.
• Utilize the table like in the above example.
• Be extremely cautious when using a leverage. Set a target based on the position volume not trying to open a position of maximum possible volume.
• Assess the correlation between the leverage and volatility. The higher is the volatility, the less should be the leverage, used in margin trading.
• Set stop orders.

Conclusion.

Don’t be afraid of using a leverage; any tool, used by a professional can generate profits. The leverage amount depends on an individual decision, there cannot be universal recommendations. One of the most efficient ways to avoid being stopped out is to strictly follow risk management and control losing trades. If you have discovered some inaccuracy or irrelevant information in the article or you would like to add anything, please, do write your comments!

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