Margin trading means trading with leverage or trading with extra funds that have been provided by the broker to enable you control positions which are larger than your own capital can carry.
Margin trading is popularly practiced in the forex market as well as in other markets. Margin trading was introduced because of the small size of currency movements. Movements of currency pairs are in the order of 0.0001 decimal places. Movements of currency prices are not whole number movements (which are commonly seen in cryptocurrencies such as Bitcoin).
The implication of these very minute movements is that large amounts of money are needed to translate these small movements into reasonable amount of money. With many traders unable to come up with such amounts, the concept of margin trading was introduced into retail forex and expanded.
For instance, a Standard Lot in forex is equivalent to a trade size of $100,000. Yet, the value of a pip with such a trade size is only $10. This is calculated by multiplying the trade size by the smallest indivisible unit of currency pair movements, which is 1 pip or 0.0001 (100,000 X 0.0001= 10). Similarly, 1 mini-lot, which is 1/10th of a Standard Lot has a trade size of $10,000 and corresponds to a pip value of $1 (10,000 X 0.0001 = 1).
How many traders have $100,000 to setup a Standard Lot position which will only yield $500 for a 50-pip profit move? Very few traders can afford this. But margin trade makes this possible. The broker provides the required leverage, which can extend from 1:5 to 1:500 or even 1:1000, while the trader comes up with a collateral sum known as margin. The ratio of the margin to the broker’s capital is what is expressed as the leverage ratio. So a leverage of 1:500 means that the trader is receiving up to 500 times the required margin from the broker. Using the single Standard Lot trade size of 100,000, the trader will be required to come up with 1/500th of 100,000 which is $200.
Margin trading is essentially what has made retail forex trading possible. If this was not the case, only the big banks would have the financial muscle to trade forex and individual traders would be locked out of the market.
What is a Margin Call?
Margin trading is a double-edged sword and can come with a cost if it is abused or misused by the trader. The margin is like a collateral for every leveraged trade. When a trade starts to go into negative position, the margin starts to be used up. In other words, it is the trader’s collateral that is used to maintain/pay for any losses being incurred in an active position. The broker’s capital (the leverage) is never allowed to be at risk. The broker’s leverage starts to be at risk when the trader’s margin is almost used up in sustaining ongoing losses in an active position. Once the trader’s margin is used up, additional funds in the trading account are pulled on to sustain the position. When these hitherto unused funds within the trading account are nearly depleted, the broker will issue an instruction to the trader to immediately fund the account to boost the trader’s margin, or the positions that are in loss territory will be closed automatically. This is what is known as the margin call.
Usually, the process of issuance of a margin call is so fast that there is hardly any time for the trader to fund the account to prevent closure of losing active positions. This process usually leads to loss of account capital.
Notice that there is a process. First, the deployed capital (margin) is used up, then the unused capital in the account is used up (the reserves) before the margin call is issued. The level to which the unused funds are depleted before the margin call is issued is what is known as the stop out level.
What is a Stop Out level?
The stop out level comes with other names: liquidation margin, minimum required margin or margin close out value.
The stop out level in forex is the specific level to which the trader’s capital that was not previously deployed into active positions is depleted below the margin, before a margin call is issued by the broker. The stop out level is the percentage to which the trader’s equity is depleted below the margin before the broker issues the margin call.
Brokers will not usually allow trades to get to the stop out level before they issue a margin call. Once a certain percentage of the stop out level is reached, the broker will issue the margin call and start to close off the active trades in the greatest losing positions in an attempt to keep the stop out level above the traded margin.
How is the stop out level calculated?
Let us assume that the trader has an account of $1000 and enters a trade with a margin of $200. If the stop out level is set at 20%, what will be the outcome if this stop out level is attained?
Equity = Balance + Unrealized profit/loss
- Starting equity is $1000 when trade is setup
- $200 will be used as margin, leaving $800 as equity when the trade is opened.
If the positions start to incur losses up to the tune of $200, then the used margin is exhausted and must be replaced immediately. If there is sufficient capital to replenish this, money will be pulled out from the capital (i.e. unused margin) to maintain the used margin figure of $200. Assuming a further $200 is pulled, the used margin will remain at $200, but the equity is now $600.
Losses extend to $400. Another $200 is taken from the account capital to keep up the used margin. Equity has now fallen to $400.
When losses extend to $600, another $200 from the equity is used to shore up the depleted used margin back to $200. At this stage, equity has dropped to $200, which means that the equity = used balance. This means that the margin level is at 100%. A margin call is issued by the broker, asking the trader to deposit more funds to keep the equity higher than the used margin.
If the margin call is ignored and trading losses continue, the broker will only allow these losses to get to the % stop out level before the automated process of closing off all losing positions, starting with the most unprofitable ones, is initiated. This means that once the equity = 20% of the margin level, the stop out level will have been reached and all positions will be liquidated completely due to lack of margin.
So if margin level is 100% when used margin is $200, the stop out level will be 1/5th of this level, which is $40. So when the position has continued to lose money until the equity is $40, all positions will be liquidated. This is how the stop out level is calculated.
Do as much as you can to understand these concepts so you can use leverage wisely.