Taming the tough option: More investors protect gains and hedge against losses than take big risks in the derivatives market. David Ford sheds some light on the trading pit

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The Independent Online
TO MOST private investors, derivatives are financial instruments used by large investing institutions, traded by young men in multi-coloured jackets - and definitely not for them.

Most derivatives markets are not open to the private investor. One derivatives market that is, however, is the equity and index traded options market of the London International Financial Futures and Options Exchange (Liffe).

The terminology and jargon that surround traded options can be off-putting. But one of the easiest ways of thinking about traded options is to consider them as a deposit. In the same way that a deposit on a house or car secures the ultimate purchase price of the item, so a traded option can secure the price of shares, whether buying them (a call option) or selling (a put option).

This purchase or sale figure is known as the exercise price or strike price. There are contracts offered with at least four strike prices for each expiry date.

The amount paid as the deposit is known as the premium and is expressed in pence per share. With traded options being traded in 1,000-share contracts, the premium needs to be multiplied by the contract size to find the overall cost per contract. As with all deposits, the premium paid is a fraction of the full purchase price of the underlying shares.

Like all deposits, equity traded options have a limited life - in this case nine months, after which they can no longer be traded or exercised. The main difference between a 'normal' deposit and a traded option is that options are securities in their own right and therefore can be traded as their value goes up and down as the underlying share price moves.

Contrary to popular belief, traded options are not inherently risky. It is the way in which they are used that determines the level of risk involved. Among the riskiest uses is speculating on the price movement of the underlying shares. If a rise is expected in the share price, a call option can be purchased (Example 1). This secures the purchase price of the shares, so the premium of the option will rise as the price of the shares rises. Once this has happened, the buyer or holder of the option can either exercise it and purchase the shares or sell it at a profit in the market.

If you expect a fall in the price of the underlying shares, a put option can be purchased (Example 2). A put option works in reverse to a call option. As the share price falls, the right to sell at the higher fixed price gains in value. The option can then either be exercised to sell the shares or sold back into the market at a profit.

While using options for speculation on price movements can produce spectacular gains and losses, their other uses are in risk management and portfolio enhancement.

Traded options can be used to hedge or insure the value of a holding (Example 3). Put options on individual shares increase in value as the share price falls. This can be used to compensate for any losses on an underlying holding and ensures its value does not fall below a certain level.

Not only is it possible to protect the value of a portfolio using options, it is also possible to enhance the returns from a share holding (Example 4). This process is known as covered call writing. Writing call options means that, in return for receiving the options premium, you give someone else the right to buy the underlying shares from you, at any time during the life of the option.

If you are required to sell the shares due to being exercised against, you are covered by the existing holding. As long as the option is not exercised, the premium received from writing the options is retained as profit. The writer also receives any dividends that are paid on the shares, further increasing the overall return from the holding.

The way an option is performing is generally expressed in one of three ways:

In the money. This means that an option already has intrinsic value. For a call option, the exercise price would be below the current share price or, for a put option, the exercise price would be above the current share price.

Out of the money. This means an option has no intrinsic value. A call option is out of the money when its exercise price is above the current share price. For a put option to be out of the money its exercise price is below the current share price.

At the money. This describes an option with an exercise price that is approximately equal to the current share price.

In order to deal in traded options an investor must go through a stockbroker. The decision as to which service to choose will depend on a number of factors including the amount of time and effort you are willing to spend, and the amount being invested.

Wise Speke, for instance, offers a conventional advisory service where the broker can be relied on to help with investment decisions. This may be on a reactive or proactive basis. They do have to ask for your approval before executing any bargain. While this is a particularly popular service, it obviously costs more than the advisory execution service. Charges start at a pounds 30 minimum commission plus contract charges.

For those with a reasonable knowledge and understanding of options, Wise Speke proposes to offer a specialist execution service. The charges are a pounds 20 opening minimum commission plus a pounds 1.40 contract charge. With this service all decisions on which stock to choose are made by the client with no help from the broker. However, while not giving advice on which stock to choose the broker will give guidance on the best option to use.

Some brokers offer a discretionary service for investors with sizeable resources to be managed. The service is managed entirely by the broker on behalf of the client with no reference before investments are made. You are informed of the decisions when deals are done. Costs start from a minimum of pounds 50 a bargain commission, plus contract charges.

Mr Ford is the author of The Investors Guide To Traded Options, published by Pitman and the Financial Times, and is a private client options broker with Wise Speke, Cutler House, 3b Devonshire Sq, London EC2M 4YA.