Leverage in Financial Products: How Does It Work and What Are the Risks?

Leverage may seem straightforward: a financial product responds more strongly to changes in the price of its underlying asset. Yet this apparent simplicity can be misleading. The leverage ratio alone tells investors little about how a product actually works, how much they could lose or which other factors may affect its value.

Leverage can arise from borrowed capital or through derivatives. However, options, warrants, knock-out products, factor certificates, futures, contracts for difference (CFDs) and leveraged exchange-traded funds (ETFs) can differ substantially in how they work. The key questions are therefore not simply how much leverage a product offers, but how that leverage is created and what its payoff profile looks like.

• How does leverage work? An explanation with a practical example
• What types of leveraged financial products are there, and how do they differ?
• When are losses limited to the initial investment, and when can they exceed it?
• Why can products with the same leverage carry different risks, and why can you lose money even when your market view is correct?
• How are derivatives used in professional fund management?

In simple terms, leverage magnifies changes in value by a given factor. In a simplified model, 2x leverage means that a price movement in the underlying asset has twice the impact on the position. This applies to both gains and losses.

Example:

Consider an investor who buys EUR 1,000 worth of shares. If the share price rises by 10%, the investment generates a profit of EUR 100. With a simplified 2x leveraged position, the profit would be EUR 200. Conversely, if the share price falls by 10%, the unleveraged investment would lose EUR 100, while the leveraged position would lose EUR 200. For simplicity, this example excludes costs and product-specific features.

The most direct way to obtain leverage is through borrowing. Suppose an investor has EUR 1,000 of their own capital, borrows another EUR 1,000 and purchases shares worth EUR 2,000. The investor now has twice as much market exposure as their own capital would otherwise allow.

A similar effect can be achieved through derivatives without investors having to take out a conventional loan themselves. A derivative is a financial instrument whose value depends on another asset, known as the underlying. Underlying assets may include shares, bonds, indices, commodities or currencies. Derivatives can involve leverage, but they are not necessarily leveraged products.

Even when investors do not borrow directly, leveraged instruments may contain an implicit financing component. Financing costs are therefore an important consideration. The stated leverage ratio captures only part of a product's overall economic characteristics.

The term "leveraged financial products" covers instruments with very different characteristics. An option works differently from a futures contract, just as a knock-out certificate differs from a daily leveraged ETF. The leverage ratio alone therefore provides an incomplete picture of a product's risk/return profile.

• Options: The first distinction is between call and put options. A call option generally increases in value when the underlying asset moves favourably upwards. A put option, by contrast, can benefit from falling prices and may also be used to hedge a portfolio. When buying an option, the potential loss is generally limited to the premium paid. Selling an option as the writer, however, involves a different payoff profile and may create substantially greater obligations.
• Warrants have similar economic characteristics to options but are typically issued by a third-party issuer and are often available in smaller denominations. In addition to movements in the underlying asset, factors such as time to expiry, volatility and the bid-ask spread can affect their price. Investors also face issuer risk.
• Knock-out and turbo certificates feature a barrier, also known as the knock-out level. If this level is reached, the product may become worthless or retain a residual value, depending on its structure. A subsequent recovery in the underlying asset generally does not reverse a knock-out event that has already occurred. The barrier is therefore a defining feature of the product's payoff profile.
• Futures work differently. Entering a futures position does not require the full notional value of the contract to be funded upfront. Instead, investors post collateral, known as initial margin. Changes in market value are settled on an ongoing basis through variation margin. If the market moves sharply against the position, additional capital may be required.
• Contracts for difference (CFDs) are also based on margin. Unlike exchange-traded futures, CFDs are over-the-counter (OTC) contracts between an investor and a counterparty. Their precise risk characteristics therefore depend heavily on the contractual terms and applicable regulatory framework.
• Factor certificates and many leveraged ETFs have additional characteristics. Their target leverage is reset regularly, often daily. As a result, what matters is not only where the underlying asset starts and ends, but also the price movements in between. This is known as path dependency. It can mean that even if an underlying asset fully recovers after a decline, the leveraged product does not return to its original value.

One of the most important questions about leveraged financial products is not "How much leverage does the product offer?" but "What happens in the worst-case scenario?"

When purchasing a security or many securitised leveraged products, the maximum loss may be limited to the capital invested. This is generally the case when buying an option, where the maximum loss is the premium paid. Losses on many warrants, certificates and leveraged ETFs available to retail investors are also limited to the amount invested. However, limited potential losses do not make a product low-risk. Investors may still lose their entire investment.

The situation can be different for margin-based transactions. With futures and other positions held on margin, only part of the full economic exposure is posted as collateral. If an adverse market movement causes the collateral to become insufficient, a margin call may occur. The investor may then be required to provide additional funds, or the position may be closed.

Another important distinction is between buying and selling an option. An option buyer pays a premium and generally limits the potential loss to that premium. By contrast, an investor who sells an option and acts as its writer assumes a contractual obligation. The resulting risk depends on the specific option structure and can significantly exceed the premium initially received.

The capital invested or margin posted is therefore not necessarily the same as the maximum potential loss.

Two financial products offering 5x leverage do not necessarily carry the same level of risk. The leverage ratio describes only a particular relationship between movements in the underlying asset and the product's response. A product's full payoff profile contains considerably more information.

A call option, a factor certificate and a futures contract may all respond strongly to movements in the same underlying asset, yet behave very differently. For options, factors such as the premium, time to expiry and volatility play an important role. For factor certificates, regular leverage resets are crucial. Futures, meanwhile, are shaped by their notional value, margin requirements and ongoing variation margin settlements.

Correctly anticipating the general direction of the market is therefore not always enough. An underlying asset may eventually move as expected, while the leveraged product still generates a loss.

With an option, for example, the anticipated price movement may occur too late. A knock-out product may have already reached its barrier before the market reverses. In a daily leveraged product, the price path between the starting and ending values can affect performance. Financing costs and a wide bid-ask spread may further reduce returns. Changes in volatility can also be particularly important for options.

Leverage should therefore never be assessed in isolation. The underlying asset, product structure, time to expiry, costs, volatility, liquidity, distance to the knock-out barrier, issuer risk and potential additional payment obligations all contribute to the product's actual risk/return profile.

Derivatives are not inherently speculative leveraged bets. In professional fund management, they can serve a range of purposes, including hedging, establishing market exposure efficiently, tactical portfolio positioning and implementing options or volatility strategies.

Consider an equity portfolio whose market risk needs to be reduced temporarily. Rather than selling all the shares, a fund manager could use put options or short futures positions. If equity markets fall sharply, the hedge may offset part of the losses. If markets continue to rise, however, hedging incurs costs, and a purchased put option may expire worthless. Hedging is therefore not a cost-free form of insurance.

Futures can be particularly capital-efficient because only margin, rather than the full notional exposure, needs to be posted. At the same time, the margin requirement alone reveals little about a fund's actual risk exposure.

Suppose a fund holds EUR 100 mn in assets and also has futures positions with a notional value of EUR 200 mn, against which EUR 20 mn in margin has been posted. This does not automatically mean that the fund has a leverage ratio of two. What matters is which other positions the portfolio holds and what purpose the futures serve. They may increase market exposure, hedge existing risks or form part of a long-short or relative value position.

Notional values alone therefore provide an incomplete picture. The portfolio as a whole is what matters when assessing risk.

The professional use of derivatives does not eliminate risk. Counterparty risk is particularly relevant for OTC derivatives: the counterparty may fail to meet its contractual obligations. Collateral management, counterparty limits, position limits, stress tests, liquidity reserves and ongoing risk monitoring can help mitigate this risk, but cannot eliminate it entirely.

Leverage is not a financial product in itself, but a mechanism. It magnifies the impact of market movements and can arise through borrowing, derivatives or structured products.

The stated leverage ratio alone is not enough to assess a product's opportunities and risks. Investors need to understand the underlying asset, how the product is structured, which costs arise, whether a knock-out barrier exists, how margin and daily leverage resets work, and whether losses can exceed the original investment.

This is precisely why two products with the same leverage ratio can have entirely different risk/return profiles. The same principle applies in professional fund management: derivatives and leverage can only be assessed meaningfully in the context of their purpose and the overall portfolio.