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How to widen investment options

IN THE wake of the Barings dbcle, the suggestion that derivatives are a useful tool for the private investor is likely to raise more than a few eyebrows.

Nevertheless, the London International Financial Futures and Options Exchange (Liffe) and ProShare, the organisation with the mission of wider share ownership, are both promoting equity and index options to a wider audience.

Karin Forseke, Liffe's director of equity products, is well aware of the widely held view that equity options are a new invention and too complex for the private investor. She dismisses what she refers to as the first popular misconception with the fact that equity options have been traded in London since 1978 - four years before IBM introduced its first office PC.

Whereas the PC is now regarded as essential equipment in the office and in many homes, many private investors shun options due to lack of understanding of the product. With a suitable education programme, however, Liffe aims to enable individuals to benefit from using options in the same way as professionals do.

Liffe certainly looks with a tinge of jealousy at Chicago and Amsterdam, the only two option exchanges that are larger than London's. While private client use of equity options is a relatively low 20 per cent in the UK, it is between 50 and 70 per cent in Chicago and Amsterdam.

Equity options may not be for the "Sids" of British Gas share fame. Nevertheless, they can be a useful tool for a sophisticated private investor with the time and inclination to learn about their use. Here is our beginner's guide.

What is an equity option? It is an instrument that gives the holder the right, but not the obligation, to buy (or sell) a set number of shares at a fixed price, within a pre-determined period of time.

But surely they are risky? The buying of options involves a limited risk. The maximum possible loss is the price paid when entering into the contract. For example, suppose shares in ABC plc currently stand at 200p. An investor who believes the shares will rise may be willing to pay 20p for the right to purchase additional shares at 200p in six months' time. If at the end of six months the shares are below 200p, then his loss has been the cost of the option. An option contract is usually for 1,000 shares.

The unlimited risk that many people seem to associate with options is certainly possible. However, this can only come about through the uncovered - or naked - writing of options. This strategy is most definitely not recommended. Naked writing means assuming an obligation to buy or sell shares at a fixed price. If one does not have the shares, or the cash, to meet this obligation, the outcome may be disastrous.

But how can I use options to protect my existing holdings? Suppose you have to raise a certain sum in six months' time. You plan to sell a certain number of shares. You could protect yourself against a fall in price by buying an option to sell a number of the shares at a given price so that you will realise the sum required even if the share price falls.

Liffe produces a private investor pack, introducing equity and index options, and a list of brokers. Contact Kristy Grant, Liffe, Cannon Bridge, London EC4R 3XX. Tel: 0171-379-2421.