Derivatives · Beginner · 4 min

Underlying, leverage, expiry

You can identify the three terms that define any derivative and explain how leverage and expiry change the risk compared with owning the underlying.

Three questions

Derivatives come in endless variations, with product names that change from bank to bank. Comparing them feels hopeless at first.

Three questions cut through almost every product: what does it follow, how much leverage does it contain, and when does it end? This lesson explains each of them, because together they decide most of the risk.

Underlying, leverage, expiry

Comparison Three terms that define a derivative: the underlying it follows, the leverage between exposure and money paid, and the expiry date when it ends. Underlying What price it follows Leverage Exposure vs. money paid Expiry When it ends

Underlying. The asset or value the derivative follows, such as a share, an index, a currency or a commodity. A derivative can only be understood if its underlying is understood. If the underlying is exotic or illiquid, the derivative usually is too.

Leverage. The notional value is the size of the exposure: for an index future, the index level times the contract's multiplier. Leverage compares that exposure with the money you pay or post as margin. With 10:1 leverage, a 1% move in the underlying changes your money by about 10%.

Leverage hides in different forms:

Expiry. Most derivatives have an expiry, the date on which they end. Futures expire on fixed dates, options and warrants too. A share can be held for decades. A derivative runs out, so the timing of a move matters, not only its direction. For an option buyer, being right after expiry is no better than being wrong.

Some products, such as CFDs and many turbos, have no fixed expiry. But they usually carry ongoing costs, such as financing charges, which work like a slow clock in the background.

2% index, 20% margin

A fictional futures contract follows a stock index at 5,000 points, with a multiplier of 5.

The same 2% fall would cost 2% if the trader simply held an index fund worth 2,500. Leverage turned an ordinary day into a large loss.

Common mistakes

The takeaway

Every derivative has an underlying, a degree of leverage and usually an expiry. Leverage magnifies moves, and expiry means time can work against you.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

  1. 1Tap the term that magnifies gains and losses.

    Tap the chart.

    Comparison Chart for the question: Tap the term that magnifies gains and losses. Underlying What price it follows Leverage Exposure vs. money paid Expiry When it ends

    Leverage is the ratio between the exposure you control and the money you pay or post.

  2. 2A futures contract on an index at 5,000 points has a multiplier of 5. What is its notional value?

    Notional value = index level × multiplier = 5,000 × 5 = 25,000.

  3. 3Why can expiry work against an option buyer?

    Being right too late is the same as being wrong for an option buyer.

  4. 4You post 2,500 to control an exposure of 25,000. What is the leverage?

    25,000 ÷ 2,500 = 10. A 1% move in the underlying is 10% of the money posted.

of 4 correct.

Sources