What is a Stop Out Level in Forex?
In this article, we will answer the following question: What is a stop out level in Forex? We will also take a look at different examples and terms connected with stop out levels, how to avoid or completely prevent the stop out, the role of leverage with regards to the stop out, and more!
What is a Stop Out Level?
A stop out level in Forex is a specific point at which all of a trader's active positions in the foreign exchange market are closed automatically by their broker, because of a decrease in their margin levels, meaning that they can no longer support the open positions. Forex is a leveraged market, which means that for every dollar traders put up for each trade, their broker can lend them a set amount of dollars that surpasses the trader's actual capital, so they have the potential to gain more profits.
The Role of Leverage
Let's exemplify what we have mentioned above.
If you put up 500 dollars on a leverage of 1:200 for a particular trade, your broker will enable you to hold a position worth 100,000 dollars. In fact, currency movements are very tiny (e.g. a value of 0.001 per unit movement), and for this to yield decent returns, large sums of money must be invested into trade positions. A lot of traders do not have these amounts to invest, so that is why leverage was designed, in an attempt to create a ready pool of funds for Forex traders to finance their trades.
Leverage isn't perfect, and it does, in fact, come with an unwanted effect. It is capable of not only magnifying profits, but also losses. In addition, losses are taken not from the leverage money directly, but from the trader's capital. If losses get to a certain point where the trader's equity is almost wiped out, the broker will then automatically close the position, to secure the leverage money they provided earlier.
This action (known as the margin call) is a trader's nightmare. A Forex stop out level is also referred to as the critical level of equity drop within a trader's account, at which this dreaded margin call will be executed.
Grasping Stop Out Levels
If there are multiple active positions on a trader's account, it is natural for the broker to close out the least beneficial ones first, and leave the profitable ones open. Indeed, if all of the positions are in debt, they will be shut down. Various brokers have different takes on what comprises their stop out. It is important to know what your broker's stop out level and margin call is. A large amount of traders fail to check this, and just rush into opening their accounts.
Some brokers tend to claim in their trading conditions that their margin call is identical to a stop out level in Forex, or simply put, stop out level = margin call. This implies that the stop out is the point at which a margin call be will actually be issued. One unpleasant surprise of this can be that no warnings are given in advance. As a result, once the equity drops to the stop out level, all of your positions are subsequently closed.
This can very dangerous if you are new to trading currencies, or if you don't manage your account well.
Another scenario is when the stop out level is at 10%, and the margin call is at 20%. What this means is that when your equity gets to 20% of the 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 equity drops to the Forex stop out, your positions will be closed. If you have such a broker, the margin call is not a dreaded thing – it is a simple warning, and with good risk management you will most likely prevent the stop out level from being reached. These brokers may suggest you to deposit more money in order to meet the minimum margin requirement.
Stop Out Level Example
Let's look at another example. Imagine that you have a trading account with a broker that has a 50% margin call level, and a 20% stop out level. Your balance is evaluated at $10,000, and you open one trading position with a $1,000 margin. If the loss on this position reaches $9,500, your account equity turns out to be $10,000 - $ 9,500 = $500.
This is already 50% of your used margin, so the broker will issue a margin call warning as a result of this. Thereby, when your loss on your position reaches $9,800, and your account equity appears to be $10,000 - $9,800 = $200 (i.e. 20% of the used margin), it will then simply trigger a stop out, and the broker will close your losing position to prevent all future losses.
The last example (includes Euro as currency) is the following: A Forex broker has a 200%/100% margin call and a stop out level respectively, with a €1,500 balance. Imagine that you open a trading position with a €200 margin. If the loss on this position reaches the point of €1,100, your account equity becomes €1,500 - €1,100 = €400 (that is 200% of your used margin), and the margin call will be executed thereafter.
When your loss on this position gets to a rate of at least €1,300, and your account equity eventually becomes €1,500 - €1,300 = €200, this accounts for 100% of the used margin, and the Forex stop limit will close your position automatically.
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How to Avoid or Prevent Stop Out
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 orders simultaneously. Why? Because more orders mean that 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. This will allow you to control your losses. If your current trade is desperately unprofitable, there is no 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 will have no alternative but to close your position.
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't survive in the Forex market without adopting a technique that professional traders use in an attempt to cover for their losses, and to avoid the stop limit in Forex. There is no need to hide the fact that everyone will lose money at some point, it's inevitable. You can, however, take steps to ensure that you don't lose what you don't have to.
Earlier in the article we took a look at a situation in which you might be issued an advance notice. That is when the margin call is higher than the stop out level. If this is the case, you should instantly use an immediate funding method to add money to your trading account. Now, we've come to our last tip. To avoid hitting a stop out level Forex, you should only trade what you can actually afford.
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). It doesn't mean that you absolutely have to use leverage. The most successful traders only trade about 2.5% to 5% of their equity. If you get a margin call or hit a Forex stop out, 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 return to live trading.
Stop out levels are frequently overlooked by traders. Mistakes are not always the best teachers, so it is better to prevent unpleasant experiences if at all possible. That is why it's important to know the significance of stop out levels in Forex. A stop out level can be easily prevented. All you need is wise account management and, of course, trading knowledge, doubled with a good amount of trading experience.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.