When you open positions using leveraged funds (with the help of a broker’s leverage), you somehow run into the risk of a stop-out. Newbies may wonder what kind of animal is this and why is it so dangerous for a trader? It is for them (for newbies) that I will “grovel” further, because more experienced traders probably already know all this. Well, otherwise, as they say, welcome!
In order not to torment you while waiting for an answer, let’s immediately consider the definition of this term:
A stop-out is a forced closure of a trader’s position due to the insufficiency of the previously deposited guarantee (margin).
Novice traders often confuse such concepts as Margin Call and Stop Out, and many generally believe that they are one and the same thing. And although they (concepts) are really interconnected, they mean completely different things. A margin call is a notification sent to a trader by a broker that the deposited collateral is not enough to maintain a position open, and a stop out is the actual closing of the position.
In other words, the margin call follows first, and only after it, and only if the trader does not replenish the margin, the stop-out is closed.
Now let’s get into the essence of the issue in a little more detail and figure out what a guarantee security is and why it may not be enough.
One should start not even with the question of what is margin, but with the question of what is leverage. In the event that a broker provides you with the opportunity to open a position in an amount exceeding the amount of funds at your disposal, they say that it provides you with leverage or leverage.
How it works? In fact, everything is extremely simple here. Imagine a specific situation: let’s say you have $ 100 in your trading account, and you want to buy a share worth $ 1000. This is quite possible if the broker provides you with a leverage of 1 to 10 (this will give you the opportunity to open a position worth 10 times the amount you can pay for it).
So, you took advantage of the opportunity given to you and bought (opened a long position) a share for $ 1000 by depositing your $ 100 as collateral.
Here comes the turn for another definition:
It is customary to call the amount of money deposited by a trader to open a position using leverage as collateral (margin).
Now let’s see what happens next. And then the share price inevitably changes, namely, it grows or decreases.
What happens if the price of the purchased share rises by $ 100 (up to $ 1100)? In this case, your paper profit will be $ 100 or 100% of the previously deposited guarantee, not bad!
And what happens if the share price falls by the same $ 100. You and I remember that initially (when buying a stock) we contributed one hundred dollars instead of a thousand. Your broker also remembers this, because he gave you leverage not at all out of pure altruism, but out of very prosaic (someone may even say – mercantile) considerations – to cut your commission for another open deal.
And, of course, the broker will never allow you to drive yourself into a loss, and this is exactly what would happen if you had a stock bought using leverage, which continues to decline in price by more than that which was contributed as margin.
Well, judge for yourself, what if the stock falls from $ 1000 to $ 700? Where, then, is the guarantee that you will be able to return the broker’s money in full? After all, he, in fact, borrowed you $ 900, adding them to your hundred when buying a stock. And when the share costs $ 700, then it becomes unclear to him where you will take the missing two hundred dollars (seven hundred can be gained by selling the share) in order to return his debt of $ 900.
That is why the broker hastily closes your position after the loss on it reaches the amount of the deposited margin. In other words, this will happen if the price of the previously purchased share falls from $ 1000 to $ 900. And it is this closing that is commonly called the stop-out term.
Well, yes, I almost forgot. Before closing your position (selling a share for $ 900 and returning the money previously borrowed to you), the broker will honestly warn you of his insidious intention. Moreover, he will do this in advance, without waiting for a decrease to 900, but let’s say at a price of $ 930-920 per share, so that you, if you wish, have time to replenish the margin (by adding another hundred bucks). This warning, you guessed it, is commonly referred to as margin call.