Understanding Stop Out in Forex Trading: Why, How, and Prevention

Forex trading allows traders to profit from fluctuations in the exchange rates of one currency against another. However, as with any form of trading, it comes with risks. One such risk that traders need to be particularly aware of is the “stop out.” This article explains stop out, why it happens, and how traders can prevent it.

What is stop out?

In the world of forex trading, leverage allows traders to control a larger position size than their actual deposit. But with this increased potential for profit comes the heightened risk of significant losses. A stop out event is when a trader’s free margin, which is the available funds not currently used in open positions or reserved to cover unrealised losses, falls below a predetermined level set by the broker. When this happens, the trader doesn’t have enough funds to sustain their current positions against unrealised losses. In the case of Scandinavian Capital Markets, our stop out level is 80%.

Stop out example

Imagine a trader has an account balance of $1,000 and open positions that have consumed $900 as used margin. This leaves the trader with a free margin of $100.

If the market moves against the trader’s open positions and the unrealised losses reach $150, the trader’s equity becomes $850 ($1,000 – $150). Now, the margin level is:

Equity / Used Margin x 100% = $850 / $900 x 100% = 94.4%

Should the unrealised loss continue to increase and reach $250, the equity goes down to $750, and the margin level is:

$750 / $900 x 100% = 83.3%

Once the unrealised losses reach $280, bringing the equity to $720, the margin level dips to 80%. At this point, the stop out is triggered, and the platform begins closing positions to prevent further losses.

Why does stop out happen?

The primary reason for a stop out is insufficient margin. Margin is the collateral traders deposit in their trading accounts to open positions and ensure they can cover potential losses. The margin required to open a position depends on the position size and leverage offered.

For example, a forex trading account with 1:100 leverage requires $10 of margin to open a 0.01 lot USD/JPY position. An account with 1:200 leverage requires $5 of margin to open the same position.

If the market moves against a trader’s position, the unrealised loss grows, and if there aren’t enough funds to cover these losses, a stop out event occurs. Brokers enforce stop out to prevent the trader from losing more money than they deposited and protect the broker from losses.

How does stop out happen?

Different forex trading platforms handle stop out events differently. We use MetaTrader 4 and cTrader, which have substantially different approaches to liquidation.

MetaTrader 4 (MT4) stop out

In the MT4 platform, when a stop out is triggered, it closes the biggest losing positions first. While this might seem logical, it isn’t always the most efficient way to free up margin. Closing the largest losing positions doesn’t necessarily lead to a significant increase in free margin.

cTrader stop out

The cTrader platform uses a more tailored approach to stop out events. Instead of closing entire positions, it partially closes trades, starting with those that will release the most margin. Therefore, the platform targets profitable positions first, as they will not just release margin but also increase the account balance. This method is more efficient in preventing further positions from being closed and aims to protect the trader’s remaining positions as much as possible.

How to prevent stop out?

To guard a trading account against stop out events and safeguard trading capital, traders can apply various methods, each having certain risks.

Use stop losses

Implementing a stop loss on trades allows traders to set a predefined level at which their position will be automatically closed. This ensures they can limit their potential losses and maintain sufficient margin.

Increase leverage

Requesting an increase in leverage will decrease the margin requirements. While this does provide traders with a bigger buffer, it’s a double-edged sword. Higher leverage also means increased risk, which can lead to larger losses if not used responsibly.

Deposit More Funds

By increasing the funds in their account, traders can boost their margin. However, it’s crucial to note that while this might prevent stop outs in the short term, it also means risking more capital.

Monitor and Manage

Regularly monitoring open positions, market conditions, and account balance is crucial. If a trader sees their margin nearing the stop out level, they can proactively make decisions, such as closing positions or hedging.

Conclusion

While forex trading offers significant profit opportunities, it’s not without its risks. Stop out is one such risk that can lead to a rapid depletion of a trader’s capital. By understanding why and how stop out events occur and taking measures to prevent them, traders can better position themselves for long-term success in the forex market.

When managing multiple open positions, traders must be vigilant about their overall exposure and not just the performance of individual trades. A collective unfavourable move across several positions can quickly deplete margins and lead to a stop out, even if individual trades are not in a significantly loss-making state.

Consistent monitoring, protective measures like stopping loss orders, and having a well-defined risk management strategy are crucial for traders dealing with multiple positions to avoid unpleasant financial surprises.

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