Stop-Loss Orders and Margin

We need to cover volatility before we talk about risk management.
Volatility is the rate of the change in price over a specific
period. The faster price rises or falls through time, the higher
the volatility is. Volatility is calculated as the standard deviation
of the percentage change in the daily price. Simply put,
the faster a market moves in one direction, the more volatile it
becomes and the more likely we are to see above-average price
movement relative to previous price behavior. Another way to
say this is that the higher the volatility in a market is, the more
money a trader will have to risk per trade.

One way traders can limit their risk is by using stop-loss
orders. What’s important for traders and investors to know
about stop-loss orders is that although they work most of the
time, there is no guarantee they will be filled at your price or,
in forex markets, filled at all. There are times when markets can

gap higher or lower, particularly on the Sunday opening, leaving
a stop order filled at a different price or not filled at all.
Because of this possibility, it is best to monitor your account at
all times when you are in the market.

In our trading accounts we always look to risk no more than
2 percent per trade or 6 percent per day of our risk capital. If we
are sizing up a setup or trade and determine that the risk is outside
our parameters, we do not take the trade. Before we cover
risk, though, we need to understand the dangers of margin.
In commodity futures you often can control 100 percent of a
commodity by putting down 3 to 7 percent of the cost of the
physical commodity. An example is gold. In a commodity
account you can buy 33 ounces of gold or one mini gold contract,
worth approximately $29,700, for $1,100 down. The margin
for gold thus is 27 to 1: $1,100(27) $29,700. The danger in
this is that if you bought a mini gold contract in a $5,000 account
and gold moved lower by $35 per ounce—as it did on August
11, 2008—and you did not have a stop order placed, you would
have lost over $1,100, or 22 percent of your account, in one day.

Margin is always a dangerous proposition for untried traders,
but when combined with volatility it is treacherous.
In futures we have mini contracts, yet with the surge in
volatility in commodity prices over the last several years, many
smaller account holders have been priced out of the market as
they have been forced to risk higher percentages of their
account balances. In forex the margins are even higher, and that
makes it more treacherous for novice traders. Margin in forex
can range from 50 to 1 all the way up to 400 to 1. However,
aside from the standard contract, which has a $100,000 face
value and can be controlled with $2,000 down at 50 to 1 or with

$1,000 at 100 to 1, there is also a $10,000 contract that can be
controlled for $100 at 100 to 1 and a $1,000 contract that can be
controlled with $10 down at 100 to 1. Because of these smaller
contract sizes, it is easier to stay within the 2 percent stop-loss
rule whether you are trading a $10,000 account or a $1,000
account. It is important to remember, however, that whatever
the margin rate is, if you are wrong on a trade, you will lose
the full percentage value loss of that instrument; that means
that if you go long a standard 100,000 EURUSD contract and
the euro drops 2 percent that day against the U.S. currency, you
will have lost $2,000.

When we are short-term trading, or day trading, we generally
don’t plan on leaving the screen while we are in a trade. We
try to go with multiple contracts that give us the freedom to take
a portion of our position off at a profit that is based on market
structure and short-term behavior, letting us to allow the balance
to run on the basis of longer-term market behavior. If we are
trading longer-term time-frames, or end-of-day—using a daily
chart—we will trade at least one contract. Before taking a trade,
we figure out what 2 percent of our risk capital is (0.02 multiplied
by the net liquid value of combined futures and forex
accounts), and this is the amount we can risk per trade. Along
with giving you your stop-loss, or the amount risked on the
trade, this amount will help determine your lot size.

For example, let’s say your risk capital accounts are $10,000,
and so you may risk 0.02(10,000) $200. We may know from
experience that our risk per trade on the British pound is
approximately 30 pips per contract, or $30 per mini contract.
Thus, if we can risk $200 on a day trade in GBPUSD, we divide
$30 into $200 and get 6.66. We round down to 6, which means

we can trade six minis, or a $60,000 block of GBPUSD, and we
must put a 30-pip stop on that trade once it has been entered.
Therefore, if we sell six minis at 198.00 on a day trade, we need
to place a buy stop at 198.30. If that distance seems too short
and thus unreasonable in light of the volatility in the market
and the structure on the chart, we pass on the trade or put on
fewer contracts. If we choose to take a position trade for
a longer-term period, we can sell two at 198.00 and place a
90-pip stop or a buy stop at 198.90 to keep the possible loss at
2 percent; similarly, we can sell one short GBPUSD at 198.00
and place a buy stop up at 199.80, or 180 pips above the short
position, to maintain a 2 percent loss.

Getting back to the six-lot day trade, by risking just 2 percent
in GBPUSD, we would be able to take at least two more trades
in other pairs. Alternatively, we could choose to risk 1 percent, or
$100, that is, three mini contracts, or a $30,000 block in GBPUSD
and have the freedom to trade up to five more pairs, keeping the
total risk per day to approximately 6 percent of the risk capital.

This way we have room to day trade several positions or position
trade several pairs and keep our total exposure to 6 percent.
If there is an adverse move against our positions, we adjust our
stops and risk accordingly, always maintaining a total exposure
of just 6 percent on all open positions. If our account draws
down, so does our exposure on future trades. As the account
grows, we’re able to increase our trading size. By placing the
physical stop we learn discipline and also are assured of maintaining
a reasonable risk-reward ratio by professional standards
if something unforeseen happens in our lives or in the marketplace.
Always remember to check to see if you have any active
working stop orders when you exit your trading platform.
Source: Mastering the Currency Market: Forex Strategies for High and Low Volatility Markets

Brokerage: Types of Margin

There are two types of margin: initial margin and maintenance
margin. The Federal Reserve sets the initial margin on stocks, which
has been at 50 percent for many years. This means, in our example
above, that you could not margin more than a $1,000 purchase of
Corporation X with a $1,000 cash purchase because, of the $2,000
purchase, only 50 percent, or $1,000, of it can be on margin. If, however,
you had securities in your account with a value of, say $50,000,
then your margin-buying power would be $100,000. When you make
a stock purchase on margin without sufficient collateral (cash or securities)
in your account to cover the 50 percent margin requirement,
you will get a Reg T margin call requesting you to deposit
sufficient collateral.

Brokerage firms are allowed to set what is called “maintenance
margin,” the percentage the stock price can drop before a margin
call is triggered. Through their computer systems, brokerage firms
monitor the value of the stock purchased on margin, and when the
stock starts to drop in value, usually to around 30 percent, firms
issue a maintenance margin call. Both Reg T and maintenance margin
calls can be satisfied in a number of ways; investors can send in
additional cash or deposit additional marginable securities, or some
of their current holdings can be liquidated to cover the margin call.
We promised not to deluge you with investment advice, but
we can’t help it when it comes to margin. Most people who take a
bloodbath from using margin blame it on the fact that their stocks
or the market went down. The price movement of stocks is a necessary
component of a margin call, but the problem is that no one

ever knows when a particular stock or the market as a whole will go
down. If you are still dead set on using margin, the trick is to never
be heavily margined. Far too many individuals figure that if they buy
their stock at 50 percent margin, the 20 percent spread between 50
percent margin and the 30 percent margin that triggers a maintenance
margin call is an adequate cushion. This is no longer true in
these days of volatile markets and volatile securities. It would be
wiser to not allow your account to be margined more than 25 percent,
as opposed to 50 percent, at least initially. This way, you are
more likely to be able to sustain a major drop in stock prices without
being forced to liquidate at the worst possible time.

In addition, take a look at the price history of any security you
are thinking of buying on margin. This is easy to do on the Internet;
review the historical up and down swings in price over the preceding
two years on a percentage basis, which should give you a
pretty good indication of how this stock might move after you purchase
it. A term in the securities industry—beta—is a measure of
volatility in a security in relation to the S&P 500. Beta can be used
as a quick measure of volatility, but it may not let you see the actual
swings in price.

Investor inquiries and complaints about margin have ballooned
in recent years, certainly as a result of the increasing number of individuals
employing margin in their online brokerage accounts.
This increase in inquiries and complaints prompted the NASD in
August 2000 to approve a proposed amendment to NASD rules
that would require member firms to provide retail customers with a
written statement that fully describes the risks associated with trading
securities in a margin account. The margin disclosure statement
must be provided to customers prior to, or at, the opening of an account
and annually thereafter; the statement can be delivered electronically
or on paper. The NASD permitted firms to create their
own disclosure statement so long as it contains the following specific
information:
• A customer can lose more funds than he or she deposits in
the account if the value declines.
• A firm has the right to force the sale of securities in an
account.
• A firm may notify the customer of a margin call and allow
the customer a few days to meet the call, but the firm also

can sell a customer’s securities without contacting him
or her.
• A customer cannot decide which securities should be sold
from his or her account.
• A firm can increase maintenance margin requirements at
any time.
• A firm does not have to grant a customer an extension on
a margin call.

What many would perceive as one of the biggest tricks of the
brokerage industry, at both traditional and online firms, is the manner
in which firms will “sell out” your portfolio to cover a margin
call with no notice to you. This is happening much more often at
online firms. Even at traditional firms, however,
customers are feeling the pinch as a result of the significantly higher
numbers of volatile stocks in which they are trading today. The
higher the volatility, the more margin calls are issued.
Tracy has a case pending in which her client received an e-mail
on a Saturday afternoon from his brokerage firm to inform him that
he had a maintenance margin call in the amount of $33,651. The
e-mail provided her client with wiring instructions on how to cover
the call. Acting promptly, Tracy’s client arranged for the wire transfer
of $35,000 over the weekend, and the wire transfer process was
put into effect first thing Monday morning. On Monday morning,
her client began telephoning the firm and after several tries, each
met with a busy signal, he finally got through. The firm representative
notified her client that his entire position had been liquidated
at market. The firm received Tracy’s client’s wire transfer of $35,000
that Monday afternoon.

Pertinent portions of the firm’s Brokerage Account Agreement
stated:
You are responsible for acting immediately on any buy in
or sell out notice given verbally or in writing. Your failure
to promptly deposit additional money or securities in
response to a margin call may result in the liquidation of
part or all of the securities in your account. Although we
will generally attempt to notify you of a margin call and
give you an opportunity to deposit additional equity to secure
the account, we reserve the right to institute imme-

diate discretionary liquidation without prior notice and
without giving you the opportunity to deposit additional
equity.

Tracy’s argument is that her client did act promptly and it wasn’t
his fault that the firm’s phone lines were busy. An interesting point
is that Tracy’s client might not have had a case if the firm had simply
liquidated the account Monday morning without having sent
the Friday e-mail. But the fact that it sent the e-mail and Tracy’s
client acted as promptly as possible under the circumstances (as the
agreement requires) gives rise to a viable claim.

There are also horror stories about brokerage firms permitting
customers to purchase stocks on margin well beyond their means, a
phenomenon that hardly existed before hoards of unsophisticated
investors opened online accounts. If you deal with a traditional firm
and call up to tell your broker you want to buy $100,000 worth of
XYZ Corporation with your sole remaining $50,000, ideally we
hope your broker would say, “Now wait a second, let’s take a more
careful look at doing this.” There’s no one to give you any sage
words of advice on the Internet.

Even when margin is used on less volatile securities, investors
can be severely damaged, as is often the case after a sharp market
drop. Often a rebound occurs, and the stocks that plummeted recover,
leaving investors who were sold out wringing their hands and
full of anguish. The majority of investors who were hurt in the 1987
market crash were those who were forced to sell their investments
at severe discounts because of margin calls. This happened again in
August 1998 with the Southeast Asian crisis. In both of these cases,
the market turned around almost immediately, leaving margined investors
with stinging losses.

It is hoped that with firms adhering to required disclosures, a
greater awareness will spread that brokerage firms will basically sell
you out at whim. Just because you may have gotten margin calls for
years and promptly paid them, don’t expect that you will get notification
of your next margin call. If the value of your stock drops
fast, the firm has the right to act fast, with or without you. And the
firm can pick and choose which of your securities to sell. We don’t
agree with this new trend in how margin is being handled. It is
mostly online firms that have adopted these new hasty tactics, which
deviate from the industry standard and show a total disregard for

the interests of the customer. As the rules now stand, you have a
tough, uphill battle.

You must be on your toes when it comes to margin. And, for
most of you, that means not agreeing to use margin at the drop of
a hat. When you consider that the consequence of a margin call
could be the loss of your entire portfolio, margin can be viewed as a
highly speculative venture. If your stockbroker recommends margin,
examine your downside. If, for example, he recommends margin
to purchase long-term investments, such as municipal bonds or
conservative mutual funds or stocks or bonds you intend to hold,
question how the margin cost might be greater than your return in
dividends or interest. Question the margin interest and how much
more of a return you need to overcome it. The ability to get specific
answers is one of the now highlighted benefits of having a human
stockbroker, as opposed to entering your own trades online with no
individualized input. Finally, if you receive a margin call, act fast.
Don’t assume that the firm will wait for you to come up with the
money. It may not, and the language in the customer or margin
agreement may support its action.
Source: Brokerage Fraud: What Wall Street Doesn't Want You to Know

UNDERSTAND HOW MARGIN WORKS

The easiest way to understand how margin actually works is to assume, for example, that a trader bought a stock for $50 and the price of the stock rises to $75. If the trader bought the stock in a cash account and paid for it in full, the trader would be able to earn a 50% return on the investment. But, if the trader bought the stock on margin – paying $25 in cash and borrowing $25 from a broker – the trader will have 100% return on the money invested and, of course, still owe the broker $25 plus interest.

The downside to using margin is that if the stock price decreases, substantial losses can mount quickly. For example, if the stock bought for $50 falls to $25 and the trader paid for the stock in full, the trader will lose 50% of the money. However, if the trader bought on margin, he or she will lose 100% and will still have to pay the interest owed on the loan.

In volatile markets, traders who put up an initial margin payment for a stock or currency position may, from time to time, be required to provide additional cash if the price of the stock falls. Some traders have been shocked to find out that the brokerage firm has the right to sell their securities that were bought on margin – without notification and potentially at a substantial loss to the trader. Thus, if the broker sells the trader’s stock after the price has plummeted, then the trader will lose the chance to recoup the loss if the market regains.

In currency terms, when a trader buys (goes long) or sells (goes short) a currency pair, the value of the currency pair, as an instrument, is initially close to zero. This is because (in the case of a buy) the quote currency is sold to buy an equivalent amount of the base currency. As the market rates fluctuate, the value of the currency pair position held will also fluctuate. Thus, if the rate for the currency pair goes down, the trader’s long position will lose value and become negative. To ensure that the trader can carry the risk in the case a position results in a loss, a broker will typically require sufficient margin to cover those losses.

A SIMPLE EXAMPLE
If a client opens an account with $100 000, with an agreed margin level of 5%, the client will be allowed to trade with 20 times leverage (100 divided by 5) which means that the client needs to maintain 5% of any open position. Hence, the client can have open positions to the value of $2 000 000 ($100 000 divided by 5%). As profit or loses occur, the amount that can be traded varies accordingly. Thus, if the client made a $20 000 profit one day, then he or she could have an open position of $2 400 000 ($100 000 + $20 000 = $120 000 divided by 5%).

RECOGNIZE THE RISKS
Margin accounts can be very risky and are not suitable for everyone. Before opening a margin account, understand that:

• you can lose more money than you have invested;
• you may have to deposit additional cash or securities in your account on short notice to cover market losses;
• you may be forced to sell some or all of your securities when market prices reduce the value of your securities; and
• your brokerage firm may sell some or all of your securities without consulting you to recoup the loan it made to you.

In order to protect against any of the above, you should know how a margin account works and what happens if the price of the stock purchased on margin declines. You should also know that the firm charges interest for borrowing money and realise how that will affect the total return on the investment. Be sure to ask the broker if it makes sense to trade on margin in light of financial resources, investment objectives held and tolerance for risk.

GENERAL MARGIN RULES
In general, brokers will require a margin to be deposited with the firm before trading can begin. Today, margin rates vary from 1% upwards, depending on the currency pair. For example, trading the euro against the dollar can be traded quite readily on just a 1% margin, while taking a position in a more volatile currency pair, like the South African rand against the dollar, could require a margin of 25%.

Obviously, in order to maintain a currency position, there must be sufficient funds to cover any potential loss:

• Initial margin represents the resources required to open a position.
• Variation margin represents the current profit or loss being made on any open positions.
• Maintenance margin is a minimum amount of collateral needed in the account.

MARGIN CALLS IN VOLATILE MARKETS
Many margin investors are familiar with the ‘routine’ margin call, where the broker asks for additional funds when the equity in the customer’s account declines below certain required levels. Normally, the broker will allow from 2 to 5 days to meet the call. The broker’s calls are usually based upon the value of the account at market close since various securities regulations require an end-of-day valuation of customer accounts.

However, in volatile markets, a broker may calculate the account value at the close and then continue to calculate calls on subsequent days on a real-time basis. When this happens, the investor might experience something similar to the following example with stocks:

Day 1 Close: A customer has 1000 shares of XYZ in the account. The closing price is $60, therefore, the market value of the account is $60 000. If the broker’s equity requirement is 25%, the customer must maintain $15 000 in equity in the account. If the client has an outstanding margin loan against the securities of $50 000, the client’s equity will be $10 000 ($60 000 − $50 000 = $10 000). The broker determines the client should receive a margin call for $5000 ($15 000 − $10 000 = $5000).

Day 2: At some point early in the day there has been a ‘dramatic’ move in the market and the broker contacts the client to inform him that he has x number of days to deposit $5000 in the account. Shortly thereafter, on Day 2, the broker sells the customer out without notice. What happened? In many cases, brokers have computer-generated programs that will issue an alarm (and/or take automatic action) if the equity in a customer’s account further declines.

For example, assume that the value of the XYZ stock in the customer’s account continues to decline during the morning of Day 2 by another $6000 – that is, the shares are now worth only $54 000. The customer still has a loan outstanding to the broker of $50 000, but now the broker only has $54 000 in market value securing that loan. So, based upon the subsequent decline, the broker decided to sell shares of XYZ before they could decline even further in value.

Had the value of the securities stayed at about $60 000, the broker would probably have allowed the customer the stated number of days to meet the margin call. Only because the market continued to decline did the broker exercise its right to take further action and sell out the account.

CONCLUDING REMARKS
Margin-based trading refers to trading in transaction sizes larger than the funds in the account. By leveraging the funds in the account, traders can take better advantage of small movements in the market to build up profits quickly. Conversely, leveraging an account to trade in larger transaction sizes can just as easily work against a trader and magnify losses, essentially putting most of the funds in the account at risk. As trading foreign exchange on margin can be very rewarding, a strict trading discipline should be adhered to.

In order to limit the risks, a trader should continuously monitor the status of the positions against current market prices and should run stop-loss orders for each position open.Astop-loss order specifies that an open position (trade) should be closed automatically when the exchange rate for the currency pair in question reaches the specified threshold. For long positions, the stop-loss rate is always lower than the current market exchange rate, while for short positions, it is always higher.
Source: A Foreign Exchange Primer