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LAVERAGE
What is Leveraged Forex Trading?
Leverage is a term used to describe the difference between what is in your account, and what is available for trading. In Forex trading, leverage is essential as price fluctuations are only a fraction of a cent. If you have a leverage ratio of 200 to 1, that means you can trade $200 for every $1 that is in your account. The high leverage available in Forex trading is why it is so exciting, and so potentially rewarding.
Forex Leverage And Risk
Leverage allows you to trade with more buying power than your deposit provides. This can work for you, as well as against you. Please remember the principal rule of financial management: greater profits and higher risks are intrinsically correlated. Just the same, high leverage is associated with significant risks. When leverage is 100:1, every dollar on your deposit allows you to purchase up to 100 units of another currency. For example, with a deposit of $1,000, you may purchase 100,000 EUR/USD, or 100,000 GBP/USD or 100,000 AUD/USD.
Leverage is a ratio of Trade Size/Deposit. This means that by controlling this ratio you can control your leverage and hence risk exposure. For example, if you have $1,000 on your deposit and you purchase 100,000 units of another currency, your leverage is 100:1 (100,000/1,000=100), but if you purchase 30,000 units of another currency your leverage is 30:1 (30,000/1,000).
If you purchase 1,000 units your leverage is 1:1 (1,000/1,000=1).
If you come from a stock/bonds background, you are probably thinking that a 100:1 leverage ratio is an enormous risk. It is, but leverage is also a risk control factor. First off, remember that in forex trading, the value of a single monetary unit fluctuates less than 2 percent on a daily basis, unlike the extreme point fluctuations that occur in the stock/bonds markets. Leverage does amplify loss, but it also amplifies gains. The risk of leverage is usually minimized by stop-loss and time-price limits.
What are Financial Leverage Ratios?
In traditional business courses, financial leverage ratios are ratios used to determine the solvency of a firm, and include the debt to equity ratio, the debt to assets ratio, and interest coverage, which equals EBIT/interest charges.
The concept of leverage also applies in trading, as Forex traders use leverage by trading with more dollars that are actually in their accounts.
Why is Forex So Heavily Leveraged?
Forex trades happen quickly, and involve fractions of cents. For this reason, Forex trading can involve leverage of 400 to 1.
When taking highly leveraged positions it is best to be very cautious! You can lose and be liable for this amount, not just the amount you had in your account. This is why it is recommended that you keep at least $500 in your account, even if your brokerage account has a lower minimum balance requirement.
What is the Definition of Financial Leverage?
Financial leverage is the degree to which a company or individual has borrowed money in order to continue operations. If a company is highly leveraged, it is in danger of bankruptcy if it cannot repay its debt. Leverage can be a positive thing if future income flows are sufficient to cover payments, and interest rates are low.
It can be disastrous if a company, or an individual, does not have adequate income to cover debts taken. In trading, leverage can be wonderful if it earns large gains, but disastrous if you lose. Never take a highly leveraged position if you don't have the funds to cover if you lose!
Limiting Your Risk
Leveraged trading brings either big rewards or big risk, however, there are creative ways to limit your risks. One is by the use of stop orders, so that you can limit your losses. Another is by using the time-honored technique of hedging. In finance, "hedging" is a strategy used to minimize exposure to an unwanted risk, while still allowing the investor to profit from an investment activity. Some brokerages offer a no debit balance account which serves as a final, irrevocable stop order to keep you from losing more than you have.
How Does Leverage Profit a Forex Investor?
One way of thinking about leverage is that it is a giant magnifying glass -- without leverage, your wins and your losses would be much lower.
If you make a 20% return on $1000, it is much smaller than a 20% return on $100,000. The fractional currencies you deal in mean that you have to have a large amount of money in the game in order to realize a substantial profit.
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