Leverage and Payoff

Leverage and payoff are crucial concepts in derivative contracts. Leverage is defined as the investment strategy of using borrowed money to increase the potential return of an investment. An example of a home purchase is provided to explain leverage. Suppose a buyer wants to purchase a home worth 1 crore rupees and the builder allows the buyer to pay 10 lakh rupees as an initial margin and the rest at a later date. In this scenario, the buyer has leveraged their investment by 10 times as they have paid a small amount to control a much larger asset.

If, in the future, the value of the homes in the area skyrockets due to development and government projects, the buyer can sell the home for a profit of 20 lakh rupees, even though they only paid 10 lakh rupees to own the entire home. This example illustrates the potential of high returns on investment through leverage but also highlights the danger of leveraging as a small movement in the value of the underlying asset can result in a big change in the initial investment. An example of leverage in the context of stocks is provided and leverage is explained as the contract value divided by the margin. A high level of leverage means that a small movement in the underlying asset will result in a large profit or loss on the initial investment.