Stop out level refers to the point at which all active positions in the forex market are closed automatically by a broker due to a reduction in the trader’s margin to levels that can no longer sustain the open position.
Forex is a market that operates with leverage. This means that for every dollar the trader puts up for a trade, the broker can lend the trader a certain amount of dollars that exceeds the trader’s money to a level determined by actual leverage used. So if a trader on a leverage of 1:200 puts up $500 for a trade, the broker will enable him hold a position worth $100,000. Leverage came about because it takes a lot of money to control positions in the forex market. Currency movements are very tiny (a value of 0.0001 per unit movement) and for this to give reasonable returns, large sums must be invested in trade positions. Most traders do not have these large sums to invest, so leverage was designed so as to create a ready pool of funds for traders to finance their forex trades.
However, leverage brought with it an unwanted effect: in addition to being able to magnify profits, it could also magnify losses, and these losses are taken not from the leverage money, but from the trader’s capital. If the losses get to a point where the trader’s equity is nearly wiped out, the broker will automatically close the position to protect the leverage money they have provided. This action by the broker is referred to as a margin call, and the stop out level refers to the critical level of equity drop in a trader’s account at which a margin call will be executed.
Understanding Stop Out Levels
If there are multiple active positions on a trader’s account, it is usual for the broker to close out the least profitable ones first and leave profitable ones open. If all positions are in debit, they will all be closed.
The different brokers have various takes on what constitutes their stop out level. It is important to understand what your broker’s stop out level is with respect to a margin call. Many traders rush through account opening and never bother to check, either out of ignorance or just plain carelessness. It is for such traders that the following explanation is made.
Scenario 1: Margin Call = Stop Out level
Some brokers may categorically state in their trading conditions that their margin call is 100% without any mention of a stop out level. This means that the stop out level is the point at which a margin call will be issued. No advance warnings are given. Once the equity dips to stop out level, all positions are closed.
Scenario 2: Margin call 20%; Stop out level 10%
This means that when your equity gets to 20% of margin (i.e. equity needed to sustain the position), the trader will get an advance notice from the broker to take steps to prevent stop out (see next paragraph). If nothing is done and equity drops to stop out level, all positions are closed. The percentages used are for educational purposes; look at the trading conditions in your account opening agreement to get the actual figures).
Steps Taken to Prevent Stop Out
- Do not open many orders at once. More orders means equity is used up to sustain a trade, leaving less equity as free margin to prevent margin calls.
- Use stop losses to control losses before they get out of hand.
- If a trade is hopelessly unprofitable, by all means close it. Better to close it while you still have money in your account than for the broker to do it for you and leave your account with nothing.
- Use hedging techniques. Many traders know nothing about hedging. You cannot survive long without using a technique that professionals use to cover their losses. Everyone will lose money at some point.
- If you have been issued an advance notice (i.e. margin call is higher than stop out level), immediately use an instant funding method such as a credit card to add money to your account.
Proper trade management is the best way to prevent stop outs.