When a crash can be good news

How to balance the risks of a rise or fall in the financial market? Alex Kiam shows the way

Recent weeks appear to show the FT SE-100 share index entering a period of high volatility, with wild swings taking place daily, or even hourly. Does this mean a crash is coming? Or are the so-called fundamentals so good that the stock market indices will just keep on rising? Have interest rates peaked, or is the economy overheating? Are we still following the Dow Jones, or has a Labour Government succeeded in decoupling our markets from those in the US?

So many questions, to which there are so few simple answers. For investors, perhaps the easiest way to start is by not panicking.

A volatile market increases financial risk for everyone, whether they invest directly in equities (perhaps from a windfall) and bonds, or indirectly via unit trusts, investment trusts and PEPs. But those who understand financial risk should not panic. To them a volatile market simply means a change in strategy. Whether the market falls, rises or stays put, they can continue to make money, or at least not lose it.

Profiting from a falling market

The holder of a "put option" has the right to sell a certain number of shares in a specified company at a fixed price on a specific day. Note that, as the name suggests, the holder has the option or the right to sell, not an obligation. Holders of call options have the right to buy a certain number of shares in a specific company at a set price on a specific day.

The number of shares involved depends on how many options contracts have been purchased, with one contract usually being for 1,000 shares. The price at which the shares can be bought is known as the exercise price, and taking up your option to buy is known as exercising your options. The date on which you may choose to exercise your options - or not, as the case may be - is known as the expiration date of the contracts.

An example of an options pricing table, which can be obtained from most financial pages, may look something like this:

The prices in the table show how much one contract will cost at exercise prices of 800p and 850p in each of these three months. So the option to buy 1,000 British Petroleum shares at a price of 850p in October will cost you 29p per share, or pounds 290 (1,000 x 29). Similarly, the option to sell 1,000 shares in BP at 800p in October will cost you 14p per share, or pounds 140 (1,000 x 14p).

So, if you think the market is going to collapse fairly soon, you may purchase one or more puts. As the value of BP shares drops, your right to sell will become more attractive. Imagine the price drops by 88p; then you would be delighted to be able to sell your shares at 800p, since you could buy them again at 750p. You will find the value of your option may have increased to 39p. This would give you a profit of pounds 250 (1,000 x [39 - 14]p) for an investment of just pounds 140. Not bad in a falling market.

Profiting in a volatile market

Current markets are highly volatile. So shares seem to increase in value as readily as they may fall. In this case buying a put option could be dangerous. That's because your right to sell at 800p would be worthless if the market price were over 900p.

In this situation market professionals may go for a "straddle" - one call option and one put option, with the same expiry date and the same exercise price. Should the price of the shares go up by a substantial amount, so would the value of the calls. However, the maximum amount straddlers would lose on the puts is the cost of the options.

Similarly, if the share value goes through the floor, the puts will increase in value by a large amount. But the most straddlers would lose on the calls is, again, the price of the options. The only way they would lose money, is if the shares were to stay at roughly the same price. See table, below.

The end of the world is nigh

At this point it is worth noting that you are undertaking a financial risk simply by not being in the market. Doom merchants started warning everyone of an impending stock-market crash almost two years ago. If you'd taken notice of those first warnings, you'd have missed an awful lot of fun.

The FTSE-100 was floundering around the 3,500 level in August 95, while it is currently pushing the 5,000 barrier. That's a 43 per cent rise compared to the 9 per cent you'd have realised from a typical building society account. Such a rapid rise in the stock-market is often termed a "negative crash". So it stands to reason that if you lose money by being "in" during a crash, you'll also lose money by being "out" during a negative crash.

The writer's `Understand Financial Risk in a Day' is available from TTL, PO Box 200, Harrogate HG1 2YR, for pounds 6.99 (P&P inclusive). Please make cheques payable to TTL. Alternatively, fax credit card details on 01423 526035.

Closing prices of British Petroleum options.

Underlying security price 738p

Calls Puts

Exercise Price Oct Jan Apr Oct Jan Apr

800 58 77 89 14 25 31

850 29 48 61 33 46 52