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A stop out is the end of the line for a given trader in the margin trading context since all their trading positions are instantly shut down and terminated. Simply put, a stop out is a condition in which a given trading platform decides that a trader is causing significant losses and, therefore, needs to be removed from active trading.
While a stop out is a dreaded concept from the side of active traders, brokers must reap profits and stay in business consistently. Stop out enables brokers to control their client traders' health and profitability levels without the hassle of checking up on them manually.
While stop outs are controversial in Forex, any aspiring trader must fully grasp this concept and how it works in practice.
A stop out is when a given trader reaches their critical margin proportion, enabling the brokers to seize their accounts.
Stop outs usually come after the margin call, a warning notification from a broker to the trader.
Stop outs are essential to margin trading, allowing brokers to control their margin offerings.
How Does a Stop Out Work and What is Margin Trading?
To discuss the nature and core concept of stop outs, we must first define the margin trading concept. Trading in the Forex landscape is quite different from other trading markets. One of the key differences is that Forex price movements are frequent but very limited in size. Therefore, reaping significant profits is almost impossible with limited trading budgets since a trader only stands to gain a minuscule fraction of gains from each trade.
However, the market is still brimming with active traders who possess limited trading funds, and margin trading makes it all possible. With margin trading opportunities, traders can trade volumes several times higher than their owned trading funds. Numerous brokers offer these day traders the chance to deal with significant funds and fulfil their trading strategies. Naturally, this service comes at the cost of commissions and a fraction of potential gains from trading.
With margin trading, traders can acquire the desired capital for long-term trading strategies. This process is called a position, which is open during the margin trading period. After a predetermined period, the trader will return borrowed funds to the broker, often with a small markup for their services. This way, each party is satisfied with the result – traders get to execute deals out of their financial range, and brokers get to profit from their margin services.
Of course, not every margin position is profitable since traders often make mistakes in their predictions and fail to generate profits from their trading strategies. Since this is a common occurrence in the Forex market, brokers have a system to prevent losses on their sides. Each trader gets a specific margin call and stop out level derived from dividing the trader’s entire equity by a used margin amount.
The stop out level is calculated similarly to the margin level, although it is frequently half the margin proportion. These two figures are among Forex's most important aspects for any margin trader. They determine the minimum equity/margin proportion level you must have to continue utilising the margin account.
Margin call levels are calculated depending on the specific circumstances of a given trader, their margin proportions and the overall risk associated with given Forex instruments. In most cases, a margin call is not the end of the road for traders, as it is merely a warning sign communicated by a broker. However, this warning sign needs to be taken extremely seriously, as margin calls are often very close to stop outs. Thus, diligent traders must reconsider their trading positions and carefully look at their current portfolio, eliminating all the losing positions within their accounts.
A failure to correct course will inevitably lead to a stop out event, the least desired outcome for any Forex trader. During a stop out, your entire account is effectively lost without the chance of recovery. The broker takes hold of any leftover assets in your possession to alleviate their losses. So, avoiding a stop out event should be on the list of your top priorities.
Stop Outs: A Practical Example
Let's discuss a practical use case to simplify the concept of a stop out further. Trader A has a portfolio of $100,000 in his trading account. Trader A decides to open a trading position with a margin of $20,000. Now, let’s imagine trader A’s trading proceeds have turned out negative and incurred losses of $90,000 on their margin position. Now, their equity is effectively the net sum of all positive and negative funds in their account ($100,000-$90,000= $10,000).
So, the margin call at 50% should be a wake-up call for trader A to reconsider their trading strategies and construct new tactics to stay afloat. However, if trader A proceeds to lose another $6,000, there will be no additional warnings or alternatives. The account is simply gone at this point, with all its potential gains and opportunities.
Why Are Stop Outs Important In The Forex Market?
While the nature of stop outs is quite unforgiving and severe for the trading parties, they serve a crucial purpose in the Forex market. Without stop outs, most brokers would have no leverage and safeguards against the careless activities of their traders. It is important to remember that Forex trading is very opportunistic, much like other trading markets. Full-time experts in this niche are incentivised to take risks and bet on their experience more often than not.
Moreover, numerous traders like to take chances and make risky bets utilising margin accounts. Without margin calls and, more importantly, stop outs, the brokers providing margin funds would not have any mechanisms to control their trading customers. After all, margin trading has the lion’s share in the Forex industry growth, facilitating active trades globally and increasing opportunities for small-scale traders.
All that is possible thanks to brokers and other institutions ready to supply margin funds to aspiring traders. If these institutions no longer have a consistent incentive to help out the market, the entire Forex landscape would be worse off. That is why margin calls and stop outs are essential – they enable brokers to control their funds without being unfair to their clients. The fairness factor is also crucial here, as traders receive all the information they will need for the duration of a margin position. From the very beginning, traders are aware of the margin call and stop out proportions. Therefore, diligent traders can easily estimate their minimum required funds and always keep a healthy margin proportion.
A stop out only happens to traders who fail to consistently monitor their funds and conduct basic calculations on their portfolio. Of course, there are some exceptions where traders might experience terrible luck, but in most cases, stop outs are quite predictable and preventable.
Most Reliable Ways to Avoid a Stop Out
Aside from simple diligence and careful strategising, there are several ways to keep a trader’s portfolio far from a stop out situation. Below, we discuss the most popular techniques that help traders keep their portfolios in check and avoid hitting the point of no return.
A Stop Loss Approach
A stop-loss order is a popular way to mitigate losses on a given margin position. In simple terms, a stop-loss order is given by a trader to a broker entity, agreeing to buy or sell a specific currency once it reaches a certain price. For example, if a given currency falls 10% below the desired price, the trader can sell it to mitigate losses and keep it within 10%. Stop-loss orders are perfect mechanisms for margin traders to minimise risks and trade more confidently, knowing that their potential losses will not transform into an unfortunate stop out.
Numerous diligent traders are highly familiar with risk-hedging techniques. This method is not just endemic to the Forex market, as it is an effective solution to mitigate risks on practically any trading market across the global landscape.
In simple terms, hedging one’s risks is opening an opposite position to the initial trading prediction. If trader A believes that the price of currency X will go up 20%, they can also purchase short contracts on this currency. While trader A still largely bets on the success of currency X with long positions, the purchases of short positions will significantly negate the losses in the adverse scenario.
While it might seem unintuitive to bet two opposite outcomes at once, the key is selecting a perfect proportion. With enough experience and practice, risk hedging can become second nature to any trader.
Trust the Process
Finally, we have the oldest and truest method of stabilising things in the Forex trading environment. Most traders get overexcited and opportunistic when promising new theories enter their minds. An overwhelming majority of stopped-out Forex portfolios stem from not sticking to a single strategy and trying to win as much as possible on a single position.
This is how most traders lose their positions and, subsequently, their portfolios on the Forex market. While sometimes it is best to adjust trading goals and look for another strategy, most experienced traders give simple advice – when in doubt, one should always stick to the process and avoid unnecessary risks.
While stop outs are one of the most undesirable outcomes in all Forex trading, they serve an essential function in the Forex equilibrium. Without stop outs, brokers would no longer be able to control their margin offerings, reducing the margin services across the board and resulting in fewer trades overall.
With enough experience and knowledge, stop outs will no longer limit one’s trading abilities and strategies. To become an expert trader in the Forex field, one must always consider the extent of their trading capabilities and take stop outs into the equation. With diligence and careful strategising, stop outs will not be a cause of concern in one’s long-term Forex trading goals and aspirations.