Gearing ratio

In a geared position, profit and loss are calculated on the whole value of the contract while only a percentage of that value is posted as margin. An adverse move is therefore measured against the whole contract rather than against the deposit, so a loss can exhaust the margin posted and is not limited to the amount deposited. A favourable move is measured on exactly the same basis and to exactly the same degree. Gearing is the name for that arrangement, and it is the older British term for what is more often called leverage.

The percentage in question is the margin requirement, set by the counterparty for each instrument and, in regulated markets, subject to a floor imposed by the regulator. Rulebooks and firms state it as a percent of the full contract value: the proportion that has to be posted and held for as long as the contract is open. The gearing convention states the same relationship the other way round, comparing contract value with margin. The percent form is the one supervisors use, because it reads as a constraint on the size of a position rather than as a feature of it.

A second meaning causes regular confusion. In company accounts, gearing, or the gearing ratio, means borrowings relative to shareholders' equity: a measure of how much of a company's capital is debt rather than shares. A reader of equity research meets that sense, and a reader of derivatives documentation meets the margin sense. Nothing but context separates them, and neither is a misuse of the word.

Margin is not a payment for the contract and not a cost line. It is collateral, held while the contract is open and released when it closes, which is why a position can be closed out by the firm on a margin close-out long before any view about the market has been resolved. Gearing changes nothing about the direction of a price or the likelihood of any outcome; it changes the size of the contract relative to the money held behind it, and both results move with it, in the same proportion.