In our previous article, we have talked about margin call, what it is, why it occurs, and how to avoid it. Now it’s time to discuss another important order called stop out.
⇐ How to avoid Margin Call
Stop out essentially means that the trader is about to go bankrupt. It occurs when the balance of the trading account is insufficient to maintain open trades, and so the brokerage company closes them forcibly. This unfortunate situation happens not only because the positions turn out to be unprofitable but primarily due to incorrect money management.
Today, we are going to discuss why and under what circumstances stop out occurs and how to prevent this from happening.
1. Stop Out: Definition
2. What Is Stop Out Level
3. Stop Out: Calculation Example
4. What Causes Stop Out
5. How to Avoid Getting Stop Out
6. Let’s Sum It Up
Stop Out: Definition
To explain it in layman’s terms, stop out is basically automatic liquidation of all positions in the trader’s account in cases where there is not enough money to maintain them.
To understand when this happens, you need to get to the bottom of margin trading and its unique features.
Suppose, a trader uses 1:100 leverage. He/she wishes to open a trade for EUR/USD. One lot is an equivalent of 100,000 units of base currency (in our case, that’s the euro). In the case of a 1.1700 quote, the trader would have to pay $117,000, if he/she trades without leverage. This is a pretty big amount of money not everyone can afford to spend. However, with 1:100 leverage, the trader will have to pay 100 times less than that, i.e. $1,170 per whole lot. In a nutshell, this is what the broker’s collateral is.
Sounds good, doesn’t it? But there’s a problem—the risks increase as well.
What Is Stop Out Level
Every brokerage company which allows its traders to use leverage basically provides traders with credit funds. That said, no broker is willing to lose money due to bad decisions of its traders. This is why all possible losses are incurred by the latter, and not the brokerage company.
What does stop out mean for the broker? This is a situation where the trader’s funds are almost gone and there’s nothing left to maintain losing trades. All positions are then closed forcibly. A margin level is used as an indicator to determine this. You can calculate it yourself or check it out in MetaTrader 4, as well as MetaTrader 5 trading platform.
Stop out and margin call are the two indicators which signal that the balance of the trading account is about to reach the critical point. The margin call is essentially a message whereby the brokerage company notifies the trader about the upcoming stop out but doesn’t close positions yet.
The stop out usually happens at the 50% margin level. Its calculation formula looks as follows:
Stop Out Level = Funds/Collateral Amount x 100
Let’s make calculations using the parameters listed below:
- The trader has $1000 available in his/her account;
- He/she trades using 1:100 leverage;
- He/she purchases the EUR/USD pair at the price of 1.1700;
- The trade volume is 0.2 lot.
In this case, this is the amount of money that will be used as collateral: $1,170 * 0.2 = $234.
Available funds will total: $1,000 − $234 = $766.
The margin level will be 327% : 766 / 234*100 = 327.
327 % is a safe margin level if the price moves against an open position, it will decrease and the stop out will happen once it reaches the 50% margin level.
Stop Out: Calculation Example
What should be the loss per trade for the stop out to happen? Let’s calculate it based on the example described earlier. We already know that the positions will be closed forcibly at the 50% margin level.
The allowed loss threshold can be calculated according to the following formula: Account Balance − Stop Out * Collateral Amount.
This is the figure we will get:
$1,000 – 50 % * $234 = $883
However, there can be more open positions than just one. Calculating loss for all positions simultaneously would be quite tricky. This is why it’s better to use the margin percentage shown in your trading terminal. The level above 300% can be considered safe. In that case, there’s nothing for you to worry about.
What Causes Stop Out
What scenarios can lead to the stop out? This typically happens when the price moves against you but that’s not the only thing that causes it. You may reach the critical level of loss when:
1. You don’t control the losses and don’t place the stop loss. In this case, the situation can spiral out of control at any moment.
2. You set the stop-loss orders but have too many open positions. This means that you haven’t properly developed your money management.
3. The allowed lot volume has been exceeded. Even with an accurate entry point, high profit potential and correctly placed stop loss, stop out can occur before the price actually reaches the risk threshold.
How to Avoid Getting Stop Out
The trader must understand the mechanism behind stop out and, most importantly, how to prevent it. After all, the trader’s key task is not to lose the money in the market.
Achieving that is not the easiest thing to do. Traders need to keep three key parameters in check at all times. These are namely:
1. The expected value of the trading strategy.
2. Risk management.
3. Money management system.
This means that before proceeding to trade, you need to have a clear understanding of them all, have all your calculations done and know the level of risk you can afford.
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Let’s Tackle Them One by One
The expected value demonstrates how much profit your trading strategy can generate in the long run (quarter, year, etc.). You need to test out the strategy and see whether it proves to be profitable. If you have no idea how to do that, you need to fill the gaps in your trading knowledge, complete the relevant training or seek help from the experts.
Risk management is designed to help you keep your market risks under control. It must include:
- Size of the stop loss (you do remember that you should always place it, don’t you?)
- Maximum number of losing trades per day or week
- Your safety net that protects you against emotionally-driven decisions (Risk Manager brought to you by Gerchik & Co).
Money management system stipulates the volume you will enter the trade with, what stop loss/take profit ratio is allowed with your trading strategy and in what situations you can increase your trading positions.
All of these must be a part of your trading plan and trade entry checklist.
Let’s Sum It Up
The first thing the traders must learn is to preserve money in the stock exchange. Inability to control losses is a sure way to bankruptcy, margin call and stop out.
1. Margin call is essentially a message given by the broker about the upcoming closure of open trades in case of subsequent losses. The margin level at which the margin call occurs is typically indicated in the terms and conditions of the brokerage company.
2. Stop out which can happen at the 50% margin level is a forcible liquidation of positions. You can avoid them by placing stop loss orders, choosing an accurate entry volume and keeping an eye on the margin level in the trading terminal.
If you notice that you are getting dangerously close to critical figures indicated in the “Level’ section, make sure to close all trades and identify mistakes that got you on the slippery slope. Next, we shall discuss how to calculate trading position the right way.