What Is the Liquidation Level?
The liquidation level, normally expressed as a percentage, is the point that, if reached, will initiate the automatic closure of existing positions. It is a security feature developed to prevent investors from incurring significant losses beyond a specified point and is, usually, pre-determined by the trader or the brokerage firm.
- The liquidation level, normally expressed as a percentage, is the point that, if reached, will initiate the automatic closure of existing positions.
- The liquidation level is, usually, pre-determined by the trader or the brokerage firm.
- Liquidation levels are typically associated with margin accounts.
- The liquidation level is a fail-safe, or security feature, developed to protect both traders and dealers from incurring significant losses beyond a specified point.
Understanding the Liquidation Level
In the foreign exchange market, the liquidation level is the pre-determined level, commonly known as a margin call, at which an automatically-triggered liquidation process will begin. This value is based on the specific amount of funds in a trader's margin account below which the liquidation of the trader's positions is triggered and executed at the prevailing market rates.
Typically, the liquidation level is expressed as a percentage value of the assets in a trader's margin account. If a forex trader's positions go against them, their account will eventually reach the liquidation level, unless the trader injects additional funds. Another name for liquidation level is liquidation margin. These types of forced sales of positions to meet margin requirements do not require customer approval.
Most forex traders will buy on margin, which is the act of borrowing money to purchase securities. The buyer pays only a percentage of the value of the acquired securities and borrows the rest from the bank or broker. The broker acts as a lender and assets, usually cash, in the trader's account act as collateral. Based on one's creditworthiness and other factors, the broker will set the minimum, or initial margin, and maintenance margin requirements that must be met before the trader can begin buying on margin. Maintenance margin refers to the minimum amount of money that must be in the account before the broker forces the investor to deposit more money.
With cash accounts, a broker does not have the same ability to liquidate, unless it is due to an external factor like a personal bankruptcy. A margin account, on the other hand, allows investors to borrow up to the broker-offered percentage of the purchase price of the security. However, the exact amount of the margin varies depending on the security. A typical requirement of a margin account is for the client to maintain at least 25% of their own money of the total market value of the position(s) at any given point.
Liquidation Level as a Protective Tool
The liquidation level is a fail-safe, or security feature, developed to protect both traders and dealers from incurring significant losses beyond a specified point. When a forex trader's account funding reaches the liquidation level, all positions held by the trader will automatically close at the best available rate. The levels that can trigger this action will vary by broker or dealer with whom the trader holds their account.
Forex trading makes heavy use of leverage. The initial upfront investment, known as a margin, is required to gain access to the foreign currency market. When prices shift, margin calls force the investor to liquidate some, or all, open positions or add more funds to their account to cover margin requirements. In times of extreme market volatility, the wide swings in price could result in a rapid succession of margin calls, which presents the possibility of significant losses.
When a dealer is handling trading activity on behalf of a trader, the dealer is assuming the risk of these potential losses. Therefore, the forex dealer holding an account for a trader takes on the responsibility that the trader's positions will lose money. Another risk to the dealer is that the trader will be unable to repay the borrowed funds used to initiate the forex trades.
As such, a named liquidation level, which the trader agrees to when opening their account, will fix the minimum margin requirement. This margin requirement, expressed as a percentage, is what the forex dealer will tolerate before automatically liquidating the trader's assets to avoid the possibility of default. This action serves as a protective measure, which gives the dealer some assurance that they have mitigated their exposure to losses.