Leverage in derivatives
Leverage in derivatives refers to using more capital in an investment with respect to the balance that a certain economic agent has to invest.
Leverage is an investment decision and in no case an obligation, therefore, it will be the investor who decides on his level of leverage according to the investor profile that has greater or lesser risk.
It is important to mention that leverage must be controlled since its uncontrolled use can have catastrophic consequences for an investor's investment account. The leverage effect in derivatives occurs because to operate in them it is not necessary to pay out all of the capital to be invested, but only part of it.
This part is known as collateral and is necessary to have the right to operate on the financial asset in question. Therefore, by the same rule, if an investor does not have to pay all of his capital and only a part, this allows him to use more capital and generate a leverage effect or an excess of capital.
Leverage calculation formula
The calculation formula is as follows:
Leverage = Nominal Trading Volume / Account Balance
Being the nominal volume of negotiation the size of the derivatives contract that is negotiated, and the balance in account, the balance deposited in the account by the investor to invest.
Another very important concept to keep in mind is the margin call, which is an alert that warns you about the use of leverage in your position.
Its calculation formula is the following:
Margin Call = Equity / Guarantees
Equity being the balance in account plus / minus the profit or loss in the position at all times, and the guarantees the amount of capital required to operate on the asset in question.
In the event that the equity equals or falls below the guarantees, the broker will automatically close the order or orders because there is not enough capital to cover the required guarantees. Generally, the financial intermediary has alarm systems to inform about this situation before it occurs, so that the investor can react.
Ways to cover a margin call
There are three ways to cover a margin call:
- Enter an operation with the opposite sign to make a netting of the position.
- Add more capital to the account.
- Do not act, waiting for the market to turn around and the account will get out of the situation of margin call (less recommended situation).
Derivatives leverage example
Let's see a simple example of leverage in derivatives.
Suppose an investor has 50,000 deposited in his cash account associated with the market account. He decides to buy 1 Future of the Ibex 35 Plus on the market, executing the order at 9,500 points. Suppose you are retained in collateral 10,000 euros. The nominal volume of negotiation in the position is 95,000 multiplied by 10, since it is the multiplier per futures contract of the Ibex 35, in this way, the volume of negotiation is 95,000 euros.
Therefore, the leverage is as follows:
Leverage = 95,000 / 50,000 = 1.9
The investor is using 1.9 times more capital than the balance in the account. This ratio is represented as 1: 1.9 and it is a very sensible leverage considering that in unorganized markets (OTC) the leverage can be as high as 1: 500 (this is a very high leverage ratio), for example in the Forex market.