What does gearing or leverage refer to in derivatives?

Gearing, or leverage, in the context of derivatives refers to the use of borrowed funds to enhance the potential returns on an investment. When investors utilize leverage, they are essentially amplifying their exposure to a particular asset without needing to invest the full amount of capital upfront. This means that the potential gains can be significantly greater compared to investing only with one's own capital. However, it also increases the risk, as losses can similarly be amplified.

Leverage is a fundamental concept in derivatives trading, enabling participants to control larger positions with less capital, thus increasing their potential for profit. This mechanism is particularly prevalent in financial derivatives such as options, futures, and contracts for difference (CFDs), where the initial margin deposits are typically a fraction of the total position size.

Understanding this concept is crucial for managing risk and making informed investment decisions, as the use of leverage can lead to higher returns but also higher losses if the market moves against the investor's position.