The collapse of Barings Bank in 1995 was a spectacular example of the huge losses just one trader can notch up using derivatives. But these complex and highly geared financial instruments have a second, altogether more friendly face. They are often used to reduce risk, helping investors keep potential losses within known limits.
Options are securities which give the holder the right, but not the obligation, to buy or sell an underlying asset, like a share, at a pre-determined price within a certain period. They allow you to put down a small stake and give yourself exposure to a much larger investment, hopefully magnifying any gains.
If you believed the shares of a particular company were likely to rise in value, you could buy a "call" option on those shares, which would give you the right to buy them at a set price within a set period of time. If the shares actually fall below the set price throughout the life of the option you have lost your money. But if, as you had hoped, they did climb higher than the price your option contract allowed you to buy them for - the strike price - you could make a swift profit by exercising the option. That means you would be able to buy the shares at the lower price and then sell them at the market price.
A "put" option works in reverse, allowing you to sell shares at a certain price. You might buy a put option if you expected a particular share to fall.
Most people who speculate using options do not actually wait to exercise the option. The most commonly used options are traded options, which change hands on the London International Financial Futures and Options Exchange (Liffe). Gains can be realised over a very short period.
For example, if you had bought call options on GEC shares on 21 April, you could have made a return of nearly 18 per cent in just over a week. Those options were trading at pounds 5.60, rising to pounds 6.60 only nine days later.
Options are often used as part of a risk-reducing strategy. Many unit trusts offer protection against market falls by investing a proportion of their funds in derivatives. They buy put options which allow them to sell the shares for a fixed price. So if share prices do fall, the unit trust can use this contract to limit its loss.
And rather than buying options, an investor can be on the other side of the contract by selling or "writing" options. "The majority of our clients have stock and write options to take in a premium, which enhances their portfolio," says Colin Bramble, manager of traded options at stockbrokers Charles Stanley. He says using options in this way to accompany a stock portfolio is the best way to use the instruments.
The principle of options is the same as that of warrants, which are also securities giving you the right to buy shares at a certain price. However, options are far riskier, because of their short life. A traded option can have a life of up to nine months, whereas warrants often have years to expiry. "You can buy warrants with a long life... and if it all goes wrong you've got time for the underlying share to recover," says Tim Cockerill of independent financial advisers Whitechurch Securities.
Using options as investments is not a suitable strategy for the armchair investor, warns Mr Cockerill. "I have come across clients occasionally who have played with options and made money, but they've actually devoted a lot of time to it," he says. Certainly someone only used to investing in managed investments such as unit trusts and investment trusts should not consider them. "They are not suitable for 99.9 per cent of ordinary private clients," he says.
"The typical person does it as an out-and-out gamble," says Jonathan Hughes of Options Direct, stock- brokers specialising in options. "They either do it because of lack of funds - they buy the option because they can't afford the underlying stock - or they do it to get the leverage," he says.
As a speculative investment strategy, it is quite hard to make money out of options, says Mr Hughes. A lot depends on judging the short-term mood of the market, which is notoriously difficult. Equities are subject to short-term volatility which can be pronounced, although long-term gains have historically been solid.
Most clients who do speculate using options, says Colin Bramble, do so using index options, particularly FTSE 100 index options. They work in a similar way to equity options, but are exercisable into cash rather than the underlying shares. They are a way of speculating on the future trend of the stock market as a whole.
But however risky it might be to speculate using options, at least anyone who buys options can never lose more than the price of the options themselves. If you hold a call option, and the price of the underlying security does not rise above the strike price, you can simply let the option lapse.
Futures, on the other hand, are far riskier. They are essentially bets on the future price of anything from stock market indices to commodities like pork bellies and gold. And, although with futures you pay nothing upfront, the losses you stand to make are almost unlimited.
For example, if you took a pounds 10 futures contract that the FTSE 100 would rise, but in the event it fell by 100 points, you would lose pounds 1,000 (100 times pounds 10). This is why most brokers require anyone dealing in futures to have hefty accounts covering potential losses, and debts have to be settled every day.
Liffe provides information on options: 0171-379 2580; Options Direct, 0171-638 0100; Charles Stanley, 0171-739 8200;
Whitechurch Securities, 0117 9442266Reuse content