Forex trading is a popular and lucrative activity that involves buying and selling currencies in the global market. However, forex trading also comes with its own challenges and risks, especially for beginners and inexperienced traders. One of the most important concepts that every forex trader should understand is forex stop out and leverage.
Forex stop out is a situation where your broker automatically closes your open positions when your account equity falls below a certain level, known as the **stop out level**. This is done to prevent your account from going into negative balance and protect both you and your broker from further losses.
Leverage is a tool that allows you to trade with more money than you actually have in your account. Leverage is expressed as a ratio, such as 1:100, which means that for every $1 you have in your account, you can trade with $100. Leverage can magnify your profits, but also your losses, as it increases your exposure to the market movements.
In this blog, we will explain how forex stop out and leverage work, how they affect your trading performance, and how you can avoid stop out and manage your risk effectively. By the end of this blog, you will have a better understanding of these concepts and how to use them to your advantage.
How leverage works and its benefits and risks
Leverage is a tool that allows you to trade with more money than you actually have in your account. Leverage is expressed as a ratio, such as 1:100, which means that for every $1 you have in your account, you can trade with $100. This is possible because your broker lends you the difference between your account balance and the trade size.
Leverage can be beneficial because it can increase your potential profits. For example, if you have $1,000 in your account and you trade with 1:100 leverage, you can open a position worth $100,000. If the price moves in your favor by 1%, you can make a profit of $1,000, which is 100% of your initial investment.
However, leverage can also be risky because it can increase your potential losses. For example, if the price moves against you by 1%, you can lose $1,000, which is 100% of your initial investment. If the price moves further against you, you can lose more than your account balance, which means you will owe money to your broker.
How stop out level is determined and its purpose
Stop out level is a percentage that indicates the minimum amount of equity you need to maintain in your account to keep your positions open. Equity is the difference between your account balance and your floating profit or loss. For example, if you have $1,000 in your account and you have a floating profit of $200, your equity is $1,200.
Stop out level is determined by your broker and it can vary depending on the type of account, the currency pair, and the market conditions. For example, some brokers may have a stop out level of 50%, which means that if your equity falls below 50% of your used margin, your positions will be closed automatically. Other brokers may have a lower or higher stop out level, such as 20% or 80%.
The purpose of stop out level is to protect you and your broker from further losses and negative balance. When your equity reaches the stop out level, your broker will close your positions, starting from the most unprofitable one, until your equity is above the stop out level. This way, you will not lose more than your account balance and your broker will not have to chase you for the debt.
Examples of stop out scenarios and how to calculate them
Let’s look at some examples of stop out scenarios and how to calculate them. Assume that you have $1,000 in your account and you trade with 1:100 leverage. Also assume that your broker has a stop out level of 50%.
- Example 1: You buy 0.1 lot of EUR/USD at 1.2000. The required margin for this trade is $120 (0.1 x 100,000 x 1.2000 / 100). Your equity is $1,000 and your free margin is $880 ($1,000 – $120). The price drops to 1.1900, which means you have a floating loss of $100 (0.1 x 100,000 x (1.2000 – 1.1900)). Your equity is now $900 ($1,000 – $100) and your free margin is $780 ($900 – $120). Your equity is still above the stop out level, which is $60 (50% x $120), so your position is not closed yet.
- Example 2: You buy 0.1 lot of EUR/USD at 1.2000. The required margin for this trade is $120. Your equity is $1,000 and your free margin is $880. The price drops to 1.1800, which means you have a floating loss of $200. Your equity is now $800 and your free margin is $680. Your equity is below the stop out level, which is $60, so your position is closed automatically. You lose $200 and your account balance is now $800.
- Example 3: You buy 0.1 lot of EUR/USD at 1.2000. The required margin for this trade is $120. Your equity is $1,000 and your free margin is $880. The price drops to 1.1700, which means you have a floating loss of $300. Your equity is now $700 and your free margin is $580. Your equity is below the stop out level, which is $60, so your position is closed automatically. You lose $300 and your account balance is now $700.
Tips on how to avoid stop out and manage risk
To avoid stop out and manage your risk effectively, you should follow these tips:
- Use appropriate leverage. Leverage can be a double-edged sword, so you should use it wisely and according to your risk appetite. A higher leverage means a higher risk, but also a higher potential reward. A lower leverage means a lower risk, but also a lower potential reward. You should choose a leverage that suits your trading style, experience, and goals.
- Monitor your margin level. Margin level is the ratio of your equity to your used margin, expressed as a percentage. For example, if you have $1,000 in your account and you use $120 as margin, your margin level is 833% ($1,000 / $120 x 100). A higher margin level means you have more free margin and more room for price fluctuations. A lower margin level means you have less free margin and less room for price fluctuations. You should monitor your margin level regularly and make sure it is above the stop out level. You can also use margin alerts or margin calls to notify you when your margin level is low.
- Use stop loss orders. Stop loss orders are orders that close your positions automatically when the price reaches a certain level that you specify. Stop loss orders can help you limit your losses and protect your profits. You should use stop loss orders for every trade and place them at a reasonable distance from your entry price, based on your risk-reward ratio, technical analysis, and market conditions.
- Use risk management tools. Risk management tools are tools that help you calculate and control your risk exposure. For example, you can use a risk calculator to determine the optimal trade size, leverage, and stop loss level for your trade, based on your account balance, risk percentage, and target profit. You can also use a position size calculator to determine the number of lots you should trade, based on your account balance, risk percentage, and stop loss level. You can find these tools online or on your trading platform.
Conclusion
In this blog, we have learned about forex stop out and leverage, two important concepts that every forex trader should understand. We have explained how leverage works and its benefits and risks, how stop out level is determined and its purpose, and how to avoid stop out and manage risk effectively.
The key takeaways for the readers are:
- Leverage can increase your potential profits, but also your potential losses, as it increases your exposure to the market movements.
- Stop out level is the minimum amount of equity you need to maintain in your account to keep your positions open. It protects you and your broker from further losses and negative balance.
- To avoid stop out and manage your risk effectively, you should use appropriate leverage, monitor your margin level, use stop loss orders, and use risk management tools.
We hope this blog has been helpful and informative for you. If you have any questions or comments, please feel free to leave them below. We would love to hear from you and help you with your forex trading journey.
