Introduction
In financial markets, the concept of leverage may be powerful yet highly misunderstood. It attracts traders to derivatives and, subsequently, to the losses that spiral out of control.
In derivatives trading, every £1 of equity allows investors to take portions of much larger positions. The margins dictate the position size and the potential profit, but they also dictate the maximum loss when the position moves against the trader.
The combination of leverage and margins allows the maximum utility of the trader’s equity. However, the additional utility of equity positions also comes with significant additional risk.
In this article, we’ll discuss how and why leverage and margins are used in derivatives, how traders can best use them, and how quickly they can become disastrous.
Understanding Leverage: Controlling More with Less
Leverage in derivatives refers to the ability to control an asset’s large notional value while tying up very little capital. This feature of derivatives is what sets them apart from traditional investing.
For instance:
If Nifty is trading at ₹22,000, one Nifty futures contract represents 50 units, giving a total value of ₹11,00,000.
However, ₹11 lakh is not the amount required by the trader to make the purchase. A margin of ₹1.1 lakh, which is roughly 10% of the required amount, is enough.
Hence, a trader could control an asset that is worth capital 10 times greater than the value of their investment.
Consequently, a 1% change in the value of the underlying index could lead to a 10% change in the value of the capital placed.
This is the magic - and the risk - of leverage.
Margin as a Price of Participation
One of the principal purposes of margin is to offset the risk of leverage. While the greater amount of capital a trader places on a position could afford the potential profit, the gain is primarily offset by the risk of losing a greater amount of capital.
Margin in a position is defined as the minimum amount of cash that must be held in the account to open and maintain that position. This ensures that both sides of the agreement are beneficial, and that the risk of default by either side is minimized.
Margins are not fees. They are refundable and are adjusted on a daily basis for the purposes of MTM profit or loss.
This is the risk that the trader would forfeit in the event of a margin call.
Types of Margins in Derivatives
An Initial Margin which is required to open a position.
A Maintenance Margin which is the amount that must be held in the account.
A Variation Margin which is adjusted for profit and loss on a daily basis (MTM) and Maintenance Margin which is the amount that must be held in the account.
The SPAN and Exposure Margins are safety margins that are used for calculating the risk that is based on a portfolio in the Indian exchanges (such as the NSE).If your margin drops below maintenance, the broker will issue a margin call on your account, which means you must deposit more funds or be forced to liquidate your position.
Leverage is a double-edged sword which increases both profits and losses.
Consider the following example.
| Nifty Futures | Cash Market | Derivatives (10x leverage) |
| Investment | ₹11,00,000 | ₹1,10,000 |
| Nifty Movement | +1% | +1% |
| Profit | ₹11,000 | ₹11,000 |
| Return on Capital | 1% | 10% |
| Loss (if -1%) | ₹11,000 | ₹11,000 |
| Return on Capital | -1% | -10% |
The reasoning is simple, leverage increases profits and losses. A small adverse price change can wipe out a large proportion of your trading capital. For this reason, leverage must be treated carefully as a sharp tool.
The Purpose and Benefits:
Leverage, despite its risks, is not bad. Actually, it is necessary for the financial market.
Increasing Participants: Reducing the capital needed for a market increases the number of market participants, which improves price discovery and narrows the market spread.
Hedging: Investors can hedge large exposures with smaller margin outlays, making risk management more efficient at a lower cost.
Capital: Traders free up capital that can be used for other investments, optimizing overall portfolio returns.
Enables Arbitrage Opportunities:
The use of leverage by professional traders to capitalize on slight shifts in market prices is a widespread practice within the industry, as the use of leverage allows traders to use little capital to unlock greater value.
Leverage certainly helps to make markets more efficient, but only under the condition that all participants are rational and within the risk.
The Risk Side: When Leverage Turns Against You
The feeling of power and control that comes from highly leveraged positions is all-consuming, but the flipside is that it is utterly devastating when those trades turn against the trader.
Leverage flips from a tool to a trap in the following scenarios:
1. Amplified Losses
Adverse market moves when highly leveraged can lead to considerable and devastating consequences. The worst experiences are loss-triggers when traders misjudge periods of price stability.
2. Margin calls and Forced Liquidation
When balances fall under certain predetermined levels, liquidation is inevitable to stave further losses. Most traders confront this in periods of extreme market volatility.
3. Emotional Pressure
The psychological burden of significant losses can trigger emotional and rash decision-making, unilateral closure of a profitable position, and loss recovery attempts after a margin call.
4. Volatility Shock
Volatility shocks stem from extreme market conditions, such as the pandemic market crash, and can result in cascading margin calls and the collapse of leveraged positions within the market.
Leverage and Volatility: A Dangerous Relationship
The relationship between leverage and volatility is one of the worst scenarios.
As volatility increases, so do margin requirements (more collateral is demanded).
Traders with little capital must scale back their positions, and the sudden unwinding of their trades can lead to even greater volatility.
This creates a circular sequence of increasing and self-sustaining volatility, as the liquidations caused by volatility increases trigger even more volatility.
Excessive speculative activity is countered by the monitoring of leverage by regulators and exchanges.
Case Study: 2008 and 2020 Market Crashes
Leverage drove a portion of the derivatives market collapse associated with the 2008 global financial crisis. Institutions held positions on mortgage-related assets that far exceeded their capital. A collapse occurred when housing prices finally fell.
The same occurred in the COVID crash in March 2020. Global market traders were highly leveraged and faced margin calls that triggered a rapid sell-off.
These events illustrate the paradox of leverage. It increases the liquidity of a market during times of stability, then increases the likelihood of a crisis during market volatility.
Proficient Use of Leverage: Adopting Practical Guidelines on Leverage for Traders
Whether traders are retail or strategic in nature, the most important practical guideline on the use of leverage is the discipline to self-regulate leveraging. Practical guidelines on the use of leverage include the following:
1. Understand the Leverage Ratio
Understand the amount of exposure relative to the capital held in the account. Most trader blowouts are a result of the psychological effects of over-leveraging.
2. Implement Stop-Loss Orders
These orders are a trader’s best protection against abrupt market movements, covering the capital at stake, and preventing emotional decision-making.
3. Avoid Full Visibility Margin Use
Do not use 100% of the available margins. The capital of a trader passes through different market cycles, conditions, and margins. A trader should have the capital to absorb the normal day-to-day price fluctuations.
4. Continuously Assess Risk on an Individual Trade
Professional traders have a 1-2% exposure on total capital for each position. It is a good practice to provocatively accept losing positions and still remain in the market.
5. Assess Volatility Risk
When the market is highly volatile, the market risk is high, and exposure should be minimized or not traded at all. Global events and frequent crises, such as the COVID-19 pandemic, are uncertain times.
6. Position Sizing Needs to be Optimized
It is important to understand that in most cases, the largest position is not the best position. The best position is the one that meets the trader’s risk profile.
7. Assess Margins Continuously
When setting a trading strategy, a trader should cover the possible fluctuations in the margins. Otherwise, the trader will face automatic margin calls.
Leverage in the Indian Context: SEBI's Safeguards
In India, the Securities and Exchange Board of India (SEBI) and exchanges like NSE and BSE have designed robust margin frameworks to prevent the misuse of leverage.
Some key frameworks include:
Risk-based margins for each contract under the SPAN + Exposure Margin System.
Brokers real-time monitoring of client exposure.
Leverage caps set by SEBI that brokers cannot exceed.
Settlements that adjust for daily profit/loss to increase transparency.
These frameworks ensure the resilience of the Indian derivatives market, protecting it from systemic breakdowns during crises, unlike the rest of the world.
Leverage, in and of itself, is not the enemy.
Leverage, in conjunction with appropriate risk management, performance improvement, and risk reduction are all possible.
It enables hedgers to protect positions at lower costs, arbitrageurs to use capital more efficiently, and traders to adjust exposure.
Most importantly, avoid the the trap of underestimating leverage while setting tight bounds for risk containment.
Conclusion
Leverage, like margin, is integral to the trading of derivatives. Accessing more with less is powerful, but it is as equally perilous. It requires discipline, close attention, and last but not least, the willingness to appropriately adjust the level of risk.
When applied appropriately, leverage can optimize productivity, increase profitability, and facilitate advanced hedging strategies.
When applied incorrectly, however, it can turn small errors into severe losses.
Ultimately, leverage is a force, neither a friend nor a foe.
It is like a fire, which can either warm your house or burn it down; the outcome depends on your ability to harness it.
So the next time you open a position in derivatives, consider this:
It is not the leverage that creates risk, but the lack of it.
