All about appropriateness tests

Complex ETPs and appropriateness tests

Some exchange-traded products (ETPs) are straightforward and designed for long-term investing. Others are complex, meaning they can behave in ways that are harder to predict and can carry additional risks that aren’t always obvious at first glance.

On Freetrade, you’ll need to pass an appropriateness test before you can trade certain complex ETPs and other complex instruments.

This page explains:

• what ETPs are, and how ETFs fit in,
• what makes an ETP “complex”,
• the main risks
• how appropriateness tests work

The ETP landscape (ETFs, ETCs, ETNs)

ETP is an umbrella term for products that trade on an exchange like a share.

ETFs (exchange-traded funds)

An ETF is typically a fund that aims to track an index, like the FTSE 100 or S&P 500. Many ETFs hold the underlying shares/bonds. This is called physical replication. Some use derivatives, called synthetic replication.

ETCs (exchange-traded commodities)

An ETC gives exposure to commodities, like gold or oil. Some are backed by physical assets, like vaulted gold.  Others use derivatives, like futures, to track prices.

ETNs (exchange-traded notes)

An ETN is a debt note issued by a bank or issuer. It promises to pay the return of an index/strategy. Because it’s a note, you take on issuer credit risk, explained below.

Key point: Two products can look similar in the app if they’re both “exchange-traded”, but the risks can be very different depending on how they get their returns.

What makes an ETP “complex”?

A product may be considered complex when its structure or features make it harder to understand how it behaves, especially in different market conditions.

Common examples of complex ETPs include:

• Leveraged ETFs, like 2x or 3x daily returns
  
• Inverse ETFs, which aim to rise when the underlying falls
• Short or leveraged commodity ETPs
  
• Synthetic ETFs, which use derivatives rather than mainly holding the underlying assets
  
• ETNs, structured debt instruments often considered complex due to their payoff and structure, with credit risk as an added risk on top
  
• Instruments with volatility-linked or derivatives-heavy strategies, where returns depend on options/futures behaviour
  
• Cryptoasset ETPs, as they have high volatility and additional operational/market risks
  

A good rule of thumb: if a product uses leverage, short exposure, or derivatives to achieve its return, it’s more likely to be complex.

The risks of complex ETPs 

Below are the key risks you should understand before trading complex ETPs. Not all risks apply to every product.  The product’s Key Information Document (KID) and factsheet are the best place to see what applies.

1) You can lose money. Sometimes faster than you expect.

All investments can go down as well as up. With complex ETPs, losses can happen more quickly or in unexpected ways, particularly when leverage or derivatives are involved.

2) Leverage risk: magnified gains and magnified losses.

Leveraged ETPs aim to deliver a multiple of returns, for example 2x or 3x. That multiplier applies to losses too.

• If the underlying index falls 1% in a day, a 3x product may fall about 3% (before fees and tracking effects).
  
• Bigger daily moves can lead to large swings in value.
  

3) Daily reset and compounding risk

Many leveraged and inverse ETPs target a daily return. They typically reset each day.

That means the return over longer periods can be very different from “3x the index” because of compounding, especially in volatile markets.

• In choppy markets, the ETP can lose value even if the index ends up roughly flat.
  
• These products are usually designed for short-term trading, not long-term investing.
  

4) Inverse and short exposure risk

Inverse ETPs aim to move in the opposite direction of the underlying 

• If the market rises strongly, an inverse product can fall quickly.
  
• If the product is both inverse and leveraged, this effect is even stronger.
  

5) Derivatives risk: futures, swaps, and options behave differently.

If an ETP uses derivatives:

• The product may not track the “spot” price you expect. For example, oil or gas spot prices.
  
• Returns can be affected by derivatives pricing, roll costs, margin rules, and market stress.
  

6) Commodity futures “roll” risk

Commodity ETPs that use futures may need to repeatedly sell expiring contracts and buy later-dated ones. This is called rolling.

• In some markets, that rolling process can create a drag on returns over time.
  
• This is one reason a commodity ETP can underperform what people think of as the “commodity price.”
  

7) Issuer credit risk

With an ETN, you are relying on the issuer to pay what it owes.

• If the issuer becomes insolvent, you could lose money even if the underlying index performed well.
  

8) Counterparty risk: common with synthetic structures

Synthetic ETFs and some ETPs may rely on one or more counterparties, often via swaps.

• If a counterparty fails, the product could be impacted, even when collateral is used.
  

9) Tracking risk: you may not get the return you expected

Even simple ETFs can deviate from their index. Complex ETPs can deviate more, due to:

• fees and operating costs
  
• derivatives pricing
  
• transaction costs and rebalancing
  
• market stress
  

10) Liquidity risk and wider spreads

Some complex ETPs trade less frequently or have fewer active market makers.

• The bid–offer spread can be wider, increasing the cost of buying and selling.
  
• In fast-moving markets, the price can jump suddenly, and your order might execute at a less favourable price than you expected.
  

11) Volatility and gap risk: big moves can happen quickly

Markets can move suddenly. Think overnight news, economic events, and geopolitical shocks.

• Leveraged/inverse products can amplify those moves.
  
• If the price jumps past your stop level in a fast-moving market, your stop-loss order will trigger but may fill at the next available price, which could be worse than the stop price you set.
  

12) Currency risk and hedging risk

If the underlying assets are priced in another currency, changes in exchange rates can affect returns.

• Some products use currency hedging, which can reduce currency swings but introduces its own costs and may not work perfectly.
  

13) Concentration and sector/theme risk

Some ETPs focus on a narrow area, like a single sector, single country, or a small number of companies.

• Performance can be dominated by just a few holdings or one market theme.
  

14) Securities lending and collateral risk

Some funds lend out holdings to earn extra income.

• This can add small extra returns, but introduces additional operational and counterparty risks. This is often managed with collateral.
  

15) Costs and performance drag

Complex ETPs can have higher ongoing costs and additional “hidden” costs from derivatives, rebalancing, and rolling.

• Over time, costs can significantly reduce returns.
  

How to spot a complex ETP

Look for words and features like:

• “Leveraged”, “2x”, “3x”, “Ultra”, “Daily”
  
• “Inverse”, “Short”, “-1x”, “Bear”
  
• References to swaps, futures, options, or synthetic replication
  
• “Note” in the name (often an ETN)
  
• A KID that suggests the product is for advanced retail investors or short-term trading
  

What is an appropriateness test?

An appropriateness test is a short set of multiple-choice questions designed to check whether you understand the key risks of a complex product before you trade it.

It typically covers:

• how the product works, for instance, daily leverage reset.
  
• the risks you could face, such as magnified losses and compounding
  
• your investing experience and knowledge.
  

Appropriateness tests are required for certain complex instruments under FCA rules. The aim is to reduce the chance of someone trading a product they don’t understand.

What the test does, and doesn’t, do

It does

• check understanding of the main product features and risks
  
• help protect customers from accidentally trading products that are easy to misunderstand
  

It does not

• tell you whether the investment is right for you
  
• assess your full financial situation, goals, or ability to absorb losses
  
• provide investment advice
  

Passing means you’ve demonstrated basic understanding. Not that the product is “safe” or suitable for long-term investing.

What happens if you don’t pass?

If you don’t pass:

• you won’t be able to trade that category of complex product on the app. At least for now.
  
• you can try again later, after reading and learning more. The test can be retaken after a 24 hour cooling-off period. This will be indicated to you on the instrument screen.
  

A good next step is to read:

• the product’s Key Information Document (KID). Especially the risk indicator, scenarios, and “what is this product?” section
  
• the costs and charges document
  
• educational resources on leverage, derivatives, and daily compounding
  

A quick checklist before you trade a complex ETP

Before placing a trade, ask yourself:

• Do I understand what the product is trying to achieve each day, not just overall?
  
• Could I cope financially and emotionally with a large, fast loss?
  
• Am I trading this for a short-term purpose, and do I have a clear exit plan?
  
• Have I checked the KID, ongoing costs, and the spread?
  
• Do I understand the currency, derivatives, and issuer/counterparty risks (if relevant)?
  

If any of these are a “not sure”, it may be worth sticking to simpler investments until you feel more confident.