In general, leverage (or gearing) can be defined as borrowing funds to make investments. In the context of derivatives trading, investors can control large positions in derivatives for little amount of outlay or even for nothing at all. A company that doesn’t have enough capital to play financial markets can simply move between markets. In other words, it may shift its bets from a financial market (the bond market, the stock market, etc) into the derivatives market (the futures market, the options market, and to a less extent the swap market). Capital needed for taking positions in derivative instruments is generally much less than capital needed to actually take positions in bond or stock markets. In some aspects, derivatives trading is similar to buying stock on margin.

An investor needs a fraction of the price to buy on margin or to trade in the derivatives market than he would need for trading outright. Leveraged positions are for this reason potentially more profitable, but also extensively risky. If leveraged positions do underperform, a large amount of money would be wiped out. But on the contrary, if these positions fare particularly well, a lot of money can be made. This summaries the effect of leverage using derivatives.

The leverage is could be inherent to the derivative itself as with options, or using futures, it could arise because the very way those contracts are traded.

In options, leverage stems from the premium, while in the case of futures, it is obtainable through the margin mechanism. Both options and futures contacts give investors leveraged gains and losses. Therefore, investors can limit their exposure by simply lowering the leverage ratio (the amount they can control by their capital). In other words, the smaller the percentage an investor posts as his initial deposit, the bigger the leverage he has to changes in the underlying asset price in either direction, and the bigger the potential percentage profits and losses.

Leverage can also result from the notional financing of swaps. In this respect, it is usually calculated as the difference between the swap equivalent value and the market value of the swap (swap equivalent value minus its market value).