The third and last part of Finance Magnates’ educational series discusses hedging, a crucial operational part for broker-dealers. This part aims to establish a basic understanding of hedging and how broker-dealers manage their risks through hedging.
Also, read the first two parts of this three-part series: The basic definitions of the broker-dealer industry and how to price instruments and monitor trades.
Hedging
Hedging is a crucial part of broker-dealers’ risk management strategies. However, the process can be complicated and backfire if not done correctly.
Forex and CFD Markets
The foreign exchange and futures markets (such as CFDs) are complex and depend on various factors like economic indicators, geopolitical events, and market sentiment. This is why many mean reversion strategies can be effective as market makers.
Statistically, this is analogous to a coin toss, where positive and negative outcomes are largely determined by chance. However, the result is a negative expected return due to costs such as spreads, commissions, and other transaction fees. Therefore, hedging should be avoided whenever possible if it cannot mitigate these costs, according to experts.
Understanding Inventory
Every broker-dealer is expected to make a certain profit or loss each month. For example, if a broker-dealer manages 100 yards (100 billion units) and the average income is 10 USD per lot (or 100 USD per million), then the broker-dealer is expected to make:
100 × 1000 x 100 = 10 million USD.
Assuming a 2 million USD standard deviation (adjusted based on historical evidence), the monthly profit or loss may fluctuate by approximately plus or minus 2 million USD.
We know there are 252 trading days in the forex (FX) market, which equals 21 monthly trading days.
Using this, we can calculate the broker-dealer’s expected daily profit as follows:
10 million USD ÷ 21days = 476,190.48 USD ≈ 0.5 million USD per day.
With a 2 million USD standard deviation, the daily fluctuation would be:
2 million USD ÷ SQRT (21days) = 436,806 USD ≈ 0.437 million USD per day.
Now, assume all trades are executed in USD. If EUR/USD volatility averages at 100 pips (i.e., the High-Low spread of EUR/USD is typically 100 ticks), then trading 500 lots could result in:
500 lots × 10 USD per pip × 100 pips = 500,000 USD profit or loss on a given day.

NOP (Net Open Position) and Risk Management
Net Open Position (NOP) is crucial for managing a trader’s or firm’s exposure to market risk. Although there are no specific rules, a generally estimation is any NOP above 500 million USD, especially with volatility where each tick (price movement) equals 100 USD, should typically be hedged to reduce exposure.
However, when aggregating NOP, a broker-dealer is essentially aggregating random market movements, meaning the risks involved can be unpredictable and subject to variability. This randomness makes hedging ineffective because it’s hard to predict how the position will behave, leading to the conclusion that hedging NOP in these conditions may not be the best strategy.
The problem with using Value-at-Risk (VaR) for Net Open Position (NOP) is that, in its basic form, VaR is typically designed to measure risk based on broader, more typical market movements rather than specific conditions.
However, in this case:
NOP is influenced by predefined risk controls, such as Stop-Loss (the point at which a trader closes a position to limit loss) or Take-Profit (the point at which a position is closed to lock in profit).
These controls limit the range of price movement to which the trader is exposed, often as little as two ticks (a very small market movement), effectively constraining the exposure.
Since Stop-Loss and Take-Profit orders significantly restrict the range of potential price movements, the risk exposure is confined to a small, predefined range. This makes VaR unsuitable because VaR is based on the assumption that the full range of market volatility is relevant. In this case, the actual risk is limited to a much narrower range, so VaR does not accurately reflect the true risk.
If a broker-dealer has more than one product, it must typically aggregate them in a way that allows for a reasonable approximation of the overall risk. This involves normalising the volatility of each instrument relative to a reference asset and comparing the volatility of each product against that reference asset. However, many industry experts still choose not to implement this approach.
Considerations for Hedging NOP
When hedging NOP with the Liquidity Provider (LP), the broker-dealer must be careful because the margin requirements and liquidation levels differ between the broker-dealer and the LP. A broker-dealer should adjust its NOP to align with the LP’s terms. In most cases, hedging NOP is not advised because the LP often B-booked your trades, meaning they profited from the broker’s losses, and thus, hedging can put the broker-dealer at a disadvantage.
Exceptions to Hedging NOP
One key exception to hedging is concentration risk. Although there are no specific rules, in the FX industry, concentration risk can be defined as when a client holds 20% or more of the net deposit. In this case, due to their large deposit size and margin, they can start absorbing the broker-dealer’s daily profits and heavily influence P&L (Profit and Loss).
Floating Leverage
On average, traders use a leverage of 1:70, as supported by credible academic studies. Given a 1 million USD deposit, the maximum Net Open Position (NOP) would be: 1M 70:1 = 70,000,000 = 700 lots.
Assuming EUR/USD is at a 1:1 ratio (base and cross), and each tick is worth 10 USD per lot, the tick value for 700 lots would be: 700 lots×10 USD per tick = 7,000 USD per tick.
If the market moves by 100 ticks, the profit or loss would be:
100 ticks × 7,000 USD per tick=700,000 USD.
This is 200,000 USD more than the acceptable daily risk of 500,000 USD. To manage this risk, the broker-dealer need to reduce leverage by creating a leverage ladder:
50K at 500:1 = 25,000,000 = 250 lots.
50K at 200:1 = 10,000,000 = 100 lots.
50K at 100:1 = 5,000,000 = 50 lots.
50K at 50:1 = 2,500,000 = 25 lots.
50K at 25:1 = 1,250,000 = 12.5 lots.
750K at 10:1 = 7,500,000 = 75 lots.
This adds up to 512.5 lots, which is close to the target of 500 lots, aligning with the acceptable risk exposure.
The Big Trader Problem
The Big Trader Problem presents significant challenges. Such concentrated risk can potentially put a broker-dealer out of business. Therefore, it’s essential to always have the correct leverage in place.
Based on historical data, the following default leverage ratios should suffice:
Forex: Up to 500:1.
CFDs: Up to 20:1.
Crypto: Up to 5:1.
However, it must be noted that regulators in many jurisdictions strictly limit the leverage ratio offered to retail traders.
If customers request more leverage, it’s important to learn to say NO. Otherwise, the broker-dealer risk creating a paradox where it takes on the trader’s role, and the trader essentially becomes the broker-dealer—taking on unacceptable risks.
Two critical tools a broker-dealer must have in place for managing risk management are:
Correct Stop-out Levels: The stop-out level for all products should be usually 50%, but it depends on the trading environment. During periods of low market volatility, these levels can be adjusted higher. However, the appropriate level can vary based on factors such as market volatility, regulatory requirements, and the broker’s risk management policies.
Ability to Hedge NOP: It’s essential to hedge net open positions (NOP) on an aggregate basis. However, it must be noted that externalising risk comes with capital constraints.
Example:
For a 2.5 million euro deposit, without leverage limits, the maximum allowable exposure would be:
2.5 million EUR × 500 = 12,500 lots.
Assuming EUR/USD is at a 1:1 ratio, this equates to:
12,500 lots × 100,000 USD = 1.25 billion USD position.
If the market moves 100 pips (which is a typical high-low volatility for the day), the potential loss would be:
12,500 lots × 10 USD per pip × 100 pips=12,500,000 USD loss.
This loss of 12.5 million USD in a single day is unacceptable and highlights the need for strict leverage limits and risk management controls.
Who to Hedge?
To determine who to hedge, a broker-dealer must first understand how much loss it can sustain. The earlier example had set a limit of 4 million USD, which led to the establish a 400 million USD Net Open Position (NOP) limit.
A more aggressive approach would be to analyse a broker-dealer’s daily or monthly P&L (profit and loss) to calculate the standard deviation. This way, a broker-dealer can monitor whether a large trader is causing significant losses over a short period, such as a single day, and decide if hedging is necessary.
The general idea is to avoid hedging where possible, as traders typically operate in a random market environment with inherent costs (such as spreads and commissions), which often leads to losses over time. In this case, the model the broker-dealer uses is discrete, meaning the broker-dealer controls the rules and can limit various factors, such as leverage and stop-out levels, rather than relying on continuous market movements, which are unpredictable and more challenging to control.
However, it’s essential to be cautious with High-Frequency Traders (HFT), especially those who exploit latency or bad price quotes for arbitrage opportunities. These traders can cause significant short-term losses, but remember, most liquidity providers avoid dealing with them for this reason.
Should Trades Be Reversed?
Reversing trades, although complex and very risky, can be effective during periods of high volatility when traders are losing more than average. This is because the broker’s profit comes from two main components:
The spread (market risk or market maker fees): For example, the raw spread of EUR/USD is 0.2 pips, and the total spread includes an additional 0.4 pips to cover clearing fees. This essentially makes the EUR/USD all-in spread 0.6 pips to cover the costs. Therefore, on 1 lot (which is 100,000 units), it will cost a broker-dealer $3 per lot per side just to cover the fees, or as institutions often say, $30 per million (since there are 10 lots in 1 million units).
Markups on the spread (risk-free profitability): When broker-dealers offer EUR/USD, they often mark up the spread—for example, to 1.6 pips. This means the markup is 1.0 pips (1.6 pips – 0.6 pips), resulting in a risk-free profit of $10 per lot, or $100 per million.
Ideally, if a trader is losing more than $60 per million on a broker-dealer platform (excluding the markup), reversing their trades should allow the broker-dealer to break even. However, in practice, this is challenging because profits and losses are non-linear. Factors such as market volatility, slippage, and transaction costs can impact the effectiveness of reversing trades, making it difficult to achieve the expected break-even point.
However, implementing a reverse trade strategy requires sophisticated risk management and real-time analysis to avoid exacerbating losses.
Not to Hedge
Hedging is a complex task and must be based on comprehensive risk assessment rather than solely on transaction costs. Industry experts recommend that a broker-dealer should aim to limit risk by using well-structured limits first rather than hedging. These limits should include:
Limits for Traders
Broker-dealers must:
- Set a limit on volume or leverage per trading account to control risk.
- Increase the stop-out level per trading account to mitigate potential losses more aggressively.
Limits for Trading Instruments
There are many limits of trading instruments offered by broker-dealers. These limitations can be mitigated by practicing the following:
- Set a limit on volume or leverage per instrument to prevent excessive exposure to any single product.
- Increase the stop-out level per instrument, particularly for highly volatile products.
- Use expiration periods for high-volatility instruments causing negative P&L, starting with a one-week expiry to reduce potential losses.
- Restrict pending orders (time-based) before market closing and events.
- Delist illiquid trading products such as USD/DKK or USD/TRY if they consistently result in negative P&L. Illiquidity can often be observed through choppy price graphs, and profitability should be reviewed monthly on a USD per million basis.
- Negative pricing for instruments should never be allowed. For example, consider what happened with OIL prices when they went negative—stop trading immediately and close positions when this occurs, and update your Terms & Conditions to reflect this.
- Circuit breakers should be in place to stop trading activity on the platform during extreme market events.
- Requote or reject due to a significant price delta.

Why Limits Instead of Hedging?
The primary reason to apply limits rather than rely on hedging is that limits allow a broker-dealer to capture as much profit as possible while still controlling risk.
Statistics show that:
- Only 5% of traders achieve a return on investment (ROI) of more than 25%.
- Only 1% of traders achieve an ROI of more than 100%.
- Only 0.01% of traders achieve an ROI of more than 200%.
Based on these statistics, you can apply limits to accounts within these performance bands.
For example, if a customer achieves an ROI of 100%, you could limit their leverage by 50% to reduce risk.
Stop-out Levels
The following example shows how a stop-out levels work for a EUR/USD position to provide a comprehensive understanding of what volatility hedge means when stop-out levels are increased:
Assuming EUR/USD is 1:1.
A trader holds a EUR/USD position worth 1 million EUR with a 10,000 EUR deposit at 1:100 leverage. This means the trader controls a position of 1,000,000 EUR with 100 USD per movement tick.
This means that his Deposit is 10,000 EUR and his open position is 10 lots and each movement is 100.
Balance = Equity + PL
Margin Level = Equity/Used Margin x 100.
Margin Level = 10,000/10,000 x 100 = 100%
From this, the following can be deduced:
- A 0% stop-out level means the trader’s equity has reached zero. The account will be liquidated when the unrealised loss (P&L) reaches 10,000 EUR, which could occur after a 100-pip movement if each pip is worth 100 EUR for the position.
- A 20% stop-out level means the trader’s equity has reached zero. The account will be liquidated when the unrealised loss (P&L) reaches 8,000 EUR, which could occur after a 80-pip movement if each pip is worth 100 for the position.
- A 50% stop-out level means the trader’s equity has reached zero. The account will be liquidated when the unrealised loss (P&L) reaches 5,000 EUR, which could occur after a 50-pip movement if each pip is worth 100 for the position.
- At a 100% stop-out level, the account is immediately at risk because any loss, including the spread, will reduce the equity, which equals the used margin. Since the spread creates an instant loss, the account could be liquidated once the position is opened.
Broker-dealers use stop-out levels as a first line of defence to protect themselves and their clients from market losses that exceed the available equity in the account. These automatic mechanisms ensure that positions are liquidated before reaching negative balance levels.
In times of high volatility, however, broker-dealers can increase stop-out levels to better control their exposure and manage the risks associated with sudden market movements, according to industry experts. Ultimately, balancing risk exposure through these mechanisms enables broker-dealers to protect their capital while ensuring market stability for their clients.
Disclaimer: This guide is for informational purposes only and is not intended as financial, legal, or operational advice. The strategies and recommendations provided may not be suitable for all broker-dealers or applicable in all jurisdictions. Readers are advised to consult with qualified professionals and regulatory authorities before implementing any of the practices discussed. The publisher assumes no responsibility for any financial losses or regulatory issues arising from the use of this content.
The third and last part of Finance Magnates’ educational series discusses hedging, a crucial operational part for broker-dealers. This part aims to establish a basic understanding of hedging and how broker-dealers manage their risks through hedging.
Also, read the first two parts of this three-part series: The basic definitions of the broker-dealer industry and how to price instruments and monitor trades.
Hedging
Hedging is a crucial part of broker-dealers’ risk management strategies. However, the process can be complicated and backfire if not done correctly.
Forex and CFD Markets
The foreign exchange and futures markets (such as CFDs) are complex and depend on various factors like economic indicators, geopolitical events, and market sentiment. This is why many mean reversion strategies can be effective as market makers.
Statistically, this is analogous to a coin toss, where positive and negative outcomes are largely determined by chance. However, the result is a negative expected return due to costs such as spreads, commissions, and other transaction fees. Therefore, hedging should be avoided whenever possible if it cannot mitigate these costs, according to experts.
Understanding Inventory
Every broker-dealer is expected to make a certain profit or loss each month. For example, if a broker-dealer manages 100 yards (100 billion units) and the average income is 10 USD per lot (or 100 USD per million), then the broker-dealer is expected to make:
100 × 1000 x 100 = 10 million USD.
Assuming a 2 million USD standard deviation (adjusted based on historical evidence), the monthly profit or loss may fluctuate by approximately plus or minus 2 million USD.
We know there are 252 trading days in the forex (FX) market, which equals 21 monthly trading days.
Using this, we can calculate the broker-dealer’s expected daily profit as follows:
10 million USD ÷ 21days = 476,190.48 USD ≈ 0.5 million USD per day.
With a 2 million USD standard deviation, the daily fluctuation would be:
2 million USD ÷ SQRT (21days) = 436,806 USD ≈ 0.437 million USD per day.
Now, assume all trades are executed in USD. If EUR/USD volatility averages at 100 pips (i.e., the High-Low spread of EUR/USD is typically 100 ticks), then trading 500 lots could result in:
500 lots × 10 USD per pip × 100 pips = 500,000 USD profit or loss on a given day.

NOP (Net Open Position) and Risk Management
Net Open Position (NOP) is crucial for managing a trader’s or firm’s exposure to market risk. Although there are no specific rules, a generally estimation is any NOP above 500 million USD, especially with volatility where each tick (price movement) equals 100 USD, should typically be hedged to reduce exposure.
However, when aggregating NOP, a broker-dealer is essentially aggregating random market movements, meaning the risks involved can be unpredictable and subject to variability. This randomness makes hedging ineffective because it’s hard to predict how the position will behave, leading to the conclusion that hedging NOP in these conditions may not be the best strategy.
The problem with using Value-at-Risk (VaR) for Net Open Position (NOP) is that, in its basic form, VaR is typically designed to measure risk based on broader, more typical market movements rather than specific conditions.
However, in this case:
NOP is influenced by predefined risk controls, such as Stop-Loss (the point at which a trader closes a position to limit loss) or Take-Profit (the point at which a position is closed to lock in profit).
These controls limit the range of price movement to which the trader is exposed, often as little as two ticks (a very small market movement), effectively constraining the exposure.
Since Stop-Loss and Take-Profit orders significantly restrict the range of potential price movements, the risk exposure is confined to a small, predefined range. This makes VaR unsuitable because VaR is based on the assumption that the full range of market volatility is relevant. In this case, the actual risk is limited to a much narrower range, so VaR does not accurately reflect the true risk.
If a broker-dealer has more than one product, it must typically aggregate them in a way that allows for a reasonable approximation of the overall risk. This involves normalising the volatility of each instrument relative to a reference asset and comparing the volatility of each product against that reference asset. However, many industry experts still choose not to implement this approach.
Considerations for Hedging NOP
When hedging NOP with the Liquidity Provider (LP), the broker-dealer must be careful because the margin requirements and liquidation levels differ between the broker-dealer and the LP. A broker-dealer should adjust its NOP to align with the LP’s terms. In most cases, hedging NOP is not advised because the LP often B-booked your trades, meaning they profited from the broker’s losses, and thus, hedging can put the broker-dealer at a disadvantage.
Exceptions to Hedging NOP
One key exception to hedging is concentration risk. Although there are no specific rules, in the FX industry, concentration risk can be defined as when a client holds 20% or more of the net deposit. In this case, due to their large deposit size and margin, they can start absorbing the broker-dealer’s daily profits and heavily influence P&L (Profit and Loss).
Floating Leverage
On average, traders use a leverage of 1:70, as supported by credible academic studies. Given a 1 million USD deposit, the maximum Net Open Position (NOP) would be: 1M 70:1 = 70,000,000 = 700 lots.
Assuming EUR/USD is at a 1:1 ratio (base and cross), and each tick is worth 10 USD per lot, the tick value for 700 lots would be: 700 lots×10 USD per tick = 7,000 USD per tick.
If the market moves by 100 ticks, the profit or loss would be:
100 ticks × 7,000 USD per tick=700,000 USD.
This is 200,000 USD more than the acceptable daily risk of 500,000 USD. To manage this risk, the broker-dealer need to reduce leverage by creating a leverage ladder:
50K at 500:1 = 25,000,000 = 250 lots.
50K at 200:1 = 10,000,000 = 100 lots.
50K at 100:1 = 5,000,000 = 50 lots.
50K at 50:1 = 2,500,000 = 25 lots.
50K at 25:1 = 1,250,000 = 12.5 lots.
750K at 10:1 = 7,500,000 = 75 lots.
This adds up to 512.5 lots, which is close to the target of 500 lots, aligning with the acceptable risk exposure.
The Big Trader Problem
The Big Trader Problem presents significant challenges. Such concentrated risk can potentially put a broker-dealer out of business. Therefore, it’s essential to always have the correct leverage in place.
Based on historical data, the following default leverage ratios should suffice:
Forex: Up to 500:1.
CFDs: Up to 20:1.
Crypto: Up to 5:1.
However, it must be noted that regulators in many jurisdictions strictly limit the leverage ratio offered to retail traders.
If customers request more leverage, it’s important to learn to say NO. Otherwise, the broker-dealer risk creating a paradox where it takes on the trader’s role, and the trader essentially becomes the broker-dealer—taking on unacceptable risks.
Two critical tools a broker-dealer must have in place for managing risk management are:
Correct Stop-out Levels: The stop-out level for all products should be usually 50%, but it depends on the trading environment. During periods of low market volatility, these levels can be adjusted higher. However, the appropriate level can vary based on factors such as market volatility, regulatory requirements, and the broker’s risk management policies.
Ability to Hedge NOP: It’s essential to hedge net open positions (NOP) on an aggregate basis. However, it must be noted that externalising risk comes with capital constraints.
Example:
For a 2.5 million euro deposit, without leverage limits, the maximum allowable exposure would be:
2.5 million EUR × 500 = 12,500 lots.
Assuming EUR/USD is at a 1:1 ratio, this equates to:
12,500 lots × 100,000 USD = 1.25 billion USD position.
If the market moves 100 pips (which is a typical high-low volatility for the day), the potential loss would be:
12,500 lots × 10 USD per pip × 100 pips=12,500,000 USD loss.
This loss of 12.5 million USD in a single day is unacceptable and highlights the need for strict leverage limits and risk management controls.
Who to Hedge?
To determine who to hedge, a broker-dealer must first understand how much loss it can sustain. The earlier example had set a limit of 4 million USD, which led to the establish a 400 million USD Net Open Position (NOP) limit.
A more aggressive approach would be to analyse a broker-dealer’s daily or monthly P&L (profit and loss) to calculate the standard deviation. This way, a broker-dealer can monitor whether a large trader is causing significant losses over a short period, such as a single day, and decide if hedging is necessary.
The general idea is to avoid hedging where possible, as traders typically operate in a random market environment with inherent costs (such as spreads and commissions), which often leads to losses over time. In this case, the model the broker-dealer uses is discrete, meaning the broker-dealer controls the rules and can limit various factors, such as leverage and stop-out levels, rather than relying on continuous market movements, which are unpredictable and more challenging to control.
However, it’s essential to be cautious with High-Frequency Traders (HFT), especially those who exploit latency or bad price quotes for arbitrage opportunities. These traders can cause significant short-term losses, but remember, most liquidity providers avoid dealing with them for this reason.
Should Trades Be Reversed?
Reversing trades, although complex and very risky, can be effective during periods of high volatility when traders are losing more than average. This is because the broker’s profit comes from two main components:
The spread (market risk or market maker fees): For example, the raw spread of EUR/USD is 0.2 pips, and the total spread includes an additional 0.4 pips to cover clearing fees. This essentially makes the EUR/USD all-in spread 0.6 pips to cover the costs. Therefore, on 1 lot (which is 100,000 units), it will cost a broker-dealer $3 per lot per side just to cover the fees, or as institutions often say, $30 per million (since there are 10 lots in 1 million units).
Markups on the spread (risk-free profitability): When broker-dealers offer EUR/USD, they often mark up the spread—for example, to 1.6 pips. This means the markup is 1.0 pips (1.6 pips – 0.6 pips), resulting in a risk-free profit of $10 per lot, or $100 per million.
Ideally, if a trader is losing more than $60 per million on a broker-dealer platform (excluding the markup), reversing their trades should allow the broker-dealer to break even. However, in practice, this is challenging because profits and losses are non-linear. Factors such as market volatility, slippage, and transaction costs can impact the effectiveness of reversing trades, making it difficult to achieve the expected break-even point.
However, implementing a reverse trade strategy requires sophisticated risk management and real-time analysis to avoid exacerbating losses.
Not to Hedge
Hedging is a complex task and must be based on comprehensive risk assessment rather than solely on transaction costs. Industry experts recommend that a broker-dealer should aim to limit risk by using well-structured limits first rather than hedging. These limits should include:
Limits for Traders
Broker-dealers must:
- Set a limit on volume or leverage per trading account to control risk.
- Increase the stop-out level per trading account to mitigate potential losses more aggressively.
Limits for Trading Instruments
There are many limits of trading instruments offered by broker-dealers. These limitations can be mitigated by practicing the following:
- Set a limit on volume or leverage per instrument to prevent excessive exposure to any single product.
- Increase the stop-out level per instrument, particularly for highly volatile products.
- Use expiration periods for high-volatility instruments causing negative P&L, starting with a one-week expiry to reduce potential losses.
- Restrict pending orders (time-based) before market closing and events.
- Delist illiquid trading products such as USD/DKK or USD/TRY if they consistently result in negative P&L. Illiquidity can often be observed through choppy price graphs, and profitability should be reviewed monthly on a USD per million basis.
- Negative pricing for instruments should never be allowed. For example, consider what happened with OIL prices when they went negative—stop trading immediately and close positions when this occurs, and update your Terms & Conditions to reflect this.
- Circuit breakers should be in place to stop trading activity on the platform during extreme market events.
- Requote or reject due to a significant price delta.

Why Limits Instead of Hedging?
The primary reason to apply limits rather than rely on hedging is that limits allow a broker-dealer to capture as much profit as possible while still controlling risk.
Statistics show that:
- Only 5% of traders achieve a return on investment (ROI) of more than 25%.
- Only 1% of traders achieve an ROI of more than 100%.
- Only 0.01% of traders achieve an ROI of more than 200%.
Based on these statistics, you can apply limits to accounts within these performance bands.
For example, if a customer achieves an ROI of 100%, you could limit their leverage by 50% to reduce risk.
Stop-out Levels
The following example shows how a stop-out levels work for a EUR/USD position to provide a comprehensive understanding of what volatility hedge means when stop-out levels are increased:
Assuming EUR/USD is 1:1.
A trader holds a EUR/USD position worth 1 million EUR with a 10,000 EUR deposit at 1:100 leverage. This means the trader controls a position of 1,000,000 EUR with 100 USD per movement tick.
This means that his Deposit is 10,000 EUR and his open position is 10 lots and each movement is 100.
Balance = Equity + PL
Margin Level = Equity/Used Margin x 100.
Margin Level = 10,000/10,000 x 100 = 100%
From this, the following can be deduced:
- A 0% stop-out level means the trader’s equity has reached zero. The account will be liquidated when the unrealised loss (P&L) reaches 10,000 EUR, which could occur after a 100-pip movement if each pip is worth 100 EUR for the position.
- A 20% stop-out level means the trader’s equity has reached zero. The account will be liquidated when the unrealised loss (P&L) reaches 8,000 EUR, which could occur after a 80-pip movement if each pip is worth 100 for the position.
- A 50% stop-out level means the trader’s equity has reached zero. The account will be liquidated when the unrealised loss (P&L) reaches 5,000 EUR, which could occur after a 50-pip movement if each pip is worth 100 for the position.
- At a 100% stop-out level, the account is immediately at risk because any loss, including the spread, will reduce the equity, which equals the used margin. Since the spread creates an instant loss, the account could be liquidated once the position is opened.
Broker-dealers use stop-out levels as a first line of defence to protect themselves and their clients from market losses that exceed the available equity in the account. These automatic mechanisms ensure that positions are liquidated before reaching negative balance levels.
In times of high volatility, however, broker-dealers can increase stop-out levels to better control their exposure and manage the risks associated with sudden market movements, according to industry experts. Ultimately, balancing risk exposure through these mechanisms enables broker-dealers to protect their capital while ensuring market stability for their clients.
Disclaimer: This guide is for informational purposes only and is not intended as financial, legal, or operational advice. The strategies and recommendations provided may not be suitable for all broker-dealers or applicable in all jurisdictions. Readers are advised to consult with qualified professionals and regulatory authorities before implementing any of the practices discussed. The publisher assumes no responsibility for any financial losses or regulatory issues arising from the use of this content.
This post is originally published on FINANCEMAGNATES.