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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, such as Forex.com, offer a no debit balance account which serves as a final, irrevocable stop order to keep you from losing more than you have.
The degree of financial leverage is defined as the percent change in earnings per share of a publicly traded company that results from a given change in earnings before interest and taxes, called EBIT. It is often referred to as DFL, and is another measure of the volatility of a given stock. An analogy can be made between Forex trading leverage, and this traditional company strength measure.
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!
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.
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.
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.
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.
There are several financial leverage formulas, but the most popular is known as the Debt to Equity formula. It is calculated by adding a company's short term and long term debt, and dividing it by its total shareholders equity.
An acceptable ratio is 2 to 1, and anything higher shows the company is at risk.
Forex trading, on the other hand, can allow leverage ratios of up to 400 to 1 - which illustrates the risk inherent in these markets.