With leverage, you can gain greater exposure to various assets like forex, gold, crypto, stocks and more. In leveraged trading, your open positions will be closed automatically when your margin level falls below the minimum requirement set by your broker, a process known as “Stop Out”. This post will explore the concept of stop out by examining all the essential concepts like margin, required margin, free margin, margin level, margin call–and offer tips to avoid a margin call, thus preventing a stop out.

What is Margin?

When trading with leverage, investors are required to put up a small amount of capital to open and maintain a new position. This capital is known as the margin. For example, if you want to buy $10,000 worth of EUR/USD, you don’t need to put up the full amount, you only need to put up a portion, e.g, $50. The actual amount depends on your broker.

Margin is not a fee or cost. It is simply a portion of your funds that your broker sets aside from your account balance to keep your position open and to ensure that you can cover the potential loss of the trade. Once your position is closed, the margin is freed or released back into your account and can be used to open new positions.

Required Margin 

Margin is expressed as a percentage of the full position size, also known as the “Notional Value” of the position you want to open. This percentage is known as the margin requirement. Margin requirement varies depending on the broker, such as 0.1%, 1%, 2%, 5%.

When margin is expressed as a specific amount of your funds, this amount is known as the required margin. Each position you maintain open will have its own required margin amount that will need to be locked up.

Take a EUR/USD trade for example. Opening a standard lot (100,000 units) of EUR/USD position without leverage would require the investor to have $100,000 in their account, assuming that EUR/USD exchange rate is close to 1.00.

However, with a margin requirement of 1%, only $1,000 of the investor’s funds would be required to open and maintain that $100,000 position. Here is the formula to calculate the required margin:

• Required Margin = Margin Requirement * Notional Value

Used Margin

Used margin is the sum of the required margin of all positions that are open. Used margin is all the margin that’s locked up and cannot be used to open new positions. While required margin is tied to a specific position, used margin refers to the amount of money you need to deposit to keep all your positions open. Let’s explain with an example.

Suppose you’ve deposited $10,000 in your account and decides to open two positions:

• Buy 0.4 standard lot (40,000 units) of EUR/USD, assuming that EUR/USD is close to 1.00.

• Buy 1 mini lot (10,000 units) of GBP/USD, assuming that GBP/USD is close to 1.00.

Your broker offers you a margin requirement of 1%. As a result, your required margin for each position goes as follows:

• EUR/USD position: $400 = $40,000 * 1%

• GBP/USD position: $100 = $10,000 * 1%

Your used margin is calculated as $500 ($400 + $100).

Free Margin

Margin can be classified as either “used” or “free”. Used margin is the sum of the required margin from all the open positions, while free margin is the difference between equity and used margin. Here is how to calculate free margin:

• Free Margin = Equity - Used Margin

At the moment when you open EUR/USD and GBP/USD positions, if there is no withdrawal or floating P/L, equity equals balance. Here is how to calculate your free margin:

• Free Margin = Equity (Balance) - Used Margin = $10,000 - $500 =$9,500

If your open positions are profiting from the market movement, your equity which partly consists of floating P/L will increase, and thus, you will have more free margin. In other words, floating profits increase equity, which increases free margin. Conversely, floating losses decrease equity, which decreases free margin.

Let’s say US dollars weakens so both your EUR/USD and GBP/USD position are profiting. The total floating profit is $100. Here is how your free margin and equity change:

• Equity = Balance + Floating P/L = $10,000 + $100 = $10,100

• Free Margin = Equity - Used Margin = $10,100 - $500 =$9,600

As for its role, free Margin serves as:

• The amount available to open new positions

• The amount that existing positions can move against you before you receive a margin call or stop out, which will be explained shortly.

Margin Level

Margin level is the ratio between equity and used margin, expressed as a percentage. The formula goes as follows:

Margin Level = (Equity / Used Margin) x 100%

The higher the margin level, the more free margin you have to trade. Conversely, the lower the margin level, the less free margin you have to trade.

Your brokers use margin levels to evaluate whether you can open additional new positions. Margin level limits vary but most brokers set this limit at 100%. This means when your equity is equal to or less than your used margin, you will not be able to open any new positions. 

Back to our example when you have a floating profit of $100. At this point, your margin level is calculated as follows:

• Margin level = (Equity / Used Margin) x 100% = ($10,100 / $500) = 2020%

Since your current margin level is way above the margin level limit (100%), you are still able to open new positions. And then you decide to buy a standard lot of AUD/USD, assuming that AUD/USD is close to 1.00. Here is how all your trading data updates, assuming that your floating P/L remains:

• Required margin for AUD/USD = Margin Requirement * Notional Value = 1% * $100,000 = $1,000

• Used Margin = Sum of all required margins = $1,000 + $400 + $100 = $1,500

• Free Margin = Equity - Used Margin = $10,100 - $1,500 = $8,600

• Current Margin Level = (Equity / Used Margin) x 100% = ($10,100/$1,500) x 100% ≈ 673%

Margin Call

Margin level is a metric decided by equity and used margin, while margin call level is a specific value of this metric. When margin call level is reached, you are in danger of the possibility of having some or all your positions forcibly closed (or liquidated). At this point, your broker may send you a margin call. A margin call is a notification from your broker via a phone call, email, or text message, telling you that your margin level has fallen below the required minimum level (i.e., margin call level).

Let’s say that the US dollar appreciates because of the Fed rate hike. All your three positions are losing with the floating loss of $9,000. This means your trading data updates as follows:

• Floating P/L = - $9,000

• Equity = Balance + Floating P/L = $10,000 - $9,000 = $1,000

• Free Margin = Equity - Used Margin = $1,000 - $1,500 = -$500

• Margin Level = (Equity / Used Margin) x 100% = = ($1,000 / $1,500) ≈ 66.7%

Since your margin level is less than the margin call level (i.e., 100%), you are not able to open any new positions until your equity becomes greater than your used margin. You can achieve this by:

• decreasing your used margin

• increasing your equity

If you decide to reduce your used margin, you can close some or all of your positions until the margin level is above the margin call level.

If you want your equity increased, either you wait for the market reversal back to your favor, or you deposit more to increase your balance and hence your equity. If you decide to wait for the market reversal, the market may continue to go against you. Once your margin level falls further to another specific level, your positions will be closed automatically. The specific level is known as the stop out level and varies by brokers.

Stop Out

A stop out level is when your margin level falls to a specified level in which one or all of your open positions are closed automatically (liquidated) by your broker to protect you from possibly incurring further losses. If this level is reached, your broker will automatically start closing out your positions with the most unprofitable one until your margin level is back above the stop out level.

The act of closing your position is called a stop out. Once the liquidation process has started, it is usually not possible to stop it since the process is automated.

Let’s assume that your broker set a stop out level at 20%. This means your brokers will automatically close your position if your margin level reaches 20%. Back to the previous example. Suppose, unfortunately, the market continues to go against you. Your floating loss now is $9,850, with AUD/USD trade being the most unprofitable position which losses $7,000. At this point, your margin level 10% (($10,000 - $9,850)/$1,500 * 100%) reaches the stop out level, and your position is automatically closed from the least profitable one. In this case, when your AUD/USD position is closed, your floating loss of $7,000 is realized and the required margin of $500 is released. Here is how your trading date updates now:

• Realized P/L = -$7,000

• Balance = Deposit + Realized P/L = $10,000 - $7,000 = $3,000

• Floating P/L = -$9,850 - (- $7,000) = -$2,850 

• Equity = Balance + Floating P/L = $3,000 + (-$2,850) = $150

• Used Margin = Sum of all required margins = $400 + $100 = $500

• Free Margin = Equity - Used Margin = $150 - $500 = -$350

• Margin Level = (Equity / Used Margin) x 100% = ($150/ $500) x 100% = 30%

Your current margin level is above the stop out level. So there is no automatic liquidation for now. However, it’s possible that the automatic liquidation continues if the market keeps going against you. In this case, the open position with the greatest unrealized loss is closed first, followed by the next largest losing position, and so on, until the margin level is back to the stop out level or higher.

Cheatsheet

To wrap up, margin is a small amount of capital in your account to open and maintain a new position. If your margin level falls below the stop out level, your open positions will be closed automatically until your margin level rises above the stop out level. The following is a cheatsheet for you to understand all relevant concepts and their relationship.

How to Avoid a Margin Call?

To avoid a margin call, it's important to manage your account's equity and use margin effectively. Here are some strategies to help keep your margin level above the required minimum and avoid having positions forcibly closed:

1. Monitor Your Positions Regularly
   Keeping a close eye on your open positions helps you stay aware of your margin level, equity, and any floating profits or losses. By tracking these metrics, you can anticipate potential margin issues and take action before your margin level falls to critical levels. Setting alerts for price movements or margin level changes can help you stay informed without constantly monitoring the market.

2. Use Stop-Loss Orders
   Implementing stop-loss orders is a proactive way to limit potential losses. A stop-loss order automatically closes a position once the price reaches a certain level, preventing further losses that could negatively impact your equity. By setting appropriate stop-loss levels, you can reduce the likelihood of a large drawdown that brings your margin level near the margin call threshold.

3. Maintain a Sufficient Account Balance
   Keeping additional funds in your account as a buffer can help you maintain a higher margin level during volatile market conditions. A well-funded account allows for more free margin, which gives you room to absorb temporary losses without triggering a margin call. Consider regularly depositing funds to top up your account, especially if you plan to open multiple positions or trade high-volatility instruments.

4. Limit Leverage Use
   While leverage can amplify profits, it also increases the risk of significant losses. Using lower leverage means you are required to maintain a smaller portion of your account as margin, reducing the strain on your equity. By trading with conservative leverage levels, you can better manage your risk and avoid putting too much pressure on your account's margin.

5. Diversify Your Positions
   Avoid over-concentrating your positions in one market or asset. Diversifying your trades across different instruments or currency pairs can help spread the risk and reduce the impact of a single adverse market movement on your margin level. This approach makes your portfolio more resilient to volatility and can help keep your margin level above the margin call threshold.

Following these practices can enhance your risk management and reduce the chance of facing a margin call, allowing you to trade with more confidence.

Conclusion

Leveraged trading offers significant opportunities for profit but comes with high risk, as trading on margin can amplify both gains and losses. Understanding the mechanics of margin, margin calls, and stop outs is crucial for managing this risk effectively. By implementing strategies like monitoring your positions, setting stop-losses, maintaining a buffer in your account, and using leverage cautiously, you can better protect your investments from sudden market fluctuations and minimize the chances of a stop out. Staying informed and proactive is key to successful and sustainable trading.