Keep your options open

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The Independent Online
Nick Leeson has probably done for derivatives what Robert Maxwell did for occupational pension schemes.

At a conservative £850m, the sheer scale of his losses in the Barings disaster will have convinced even the most adventurous private investor that any financial product in this category belongs firmly in George Soros's school of investment strategy rather than a sensible portfolio.

That Mr Leeson bet Britain's oldest merchant bank on futures contracts matters not a jot. All derivatives have again been tarred with the same brush.

Like other high-profile derivative disasters, the publicity has fuelled two common misconceptions about them. The first is that anything labeled a derivative is too complicated for private investors. The second is that you need large sums of money to get in on the action.

The truth is that anyone with a spare £200 or £300 to play with can deal in options. These derivatives are as old as the hills and are often used by more sophisticated private investor. Far from being a dangerous gamble, they are used to manage risk and also to generate extra income on a shareholding. When the market is expected to remain flat, share performance can be enhanced by using options.

Options can be traded independently of the underlying shares to take a view on the market. And unlike the underlying shares, options allow an investor to profit from price falls as well as price rises.

The London International Financial Futures and Options Exchange lists 11 member stockbroking firms prepared to deal in options for private clients. Albert E Sharp, has 180 private clients registered to deal. "They tend to be people who already have a full range of the usual investments,'' said Carl Beckley, associate director, derivatives.

Options are available on a wide range of products including individual shares - equity options - and stock market indices, or index options. By giving the investor the right to buy or sell shares for a fraction of the price of the underlying shares, options offer varied investment strategies from pure speculation to insuring a portfolio's value.

Very simply, options give the holder the right to buy or sell a product at a fixed price within a set time limit. But, unlike Mr Leeson's notorious futures contracts, there is no obligation to buy or sell.

Equity options, normally traded on Liffe in contracts representing 1,000 shares, come in two types. A "call'' option allows the holder to buy shares at a fixed price. A "put'' gives the right to sell at a fixed price. Liffe trades options on the shares of about 70 British companies.

An investor expecting Hanson shares to rise above their current price of 236p could buy 1,000 Hanson shares costing £2,360. Alternatively, the investor could buy a November 24 call option for 15p.a share. The contract for 1,000 shares would cost £150 and give the investor the right to buy 1,000 Hanson shares at 240p until expiry date on 15 November.

If, as the investor expects, Hanson's share price rises to say 280p then the call option will also rise, largely reflecting the 40p premium. It may rise to say 45p a share, giving the investor a profit of £300 on the £150 outlay, a return of 200 per cent. The percentage return on the underlying shares would have been considerably less at 18.6 per cent

Investors can also profit from an expected share price fall by purchasing put options which can be used to protect the value of share holdings from expected falls by matching the underlying holding with the required number of options.