Commodities & Futures: Options for investors

LAST WEEK in this column, the Independent divulged its commodities investment tips for 1993. Some readers may have wondered where they could put such tips to use. Herewith, a brief primer on the futures and options markets.

What are futures and options markets? Where are they?

Futures and options are traded on authorised exchanges, located in all the world's big financial centres. The biggest and oldest futures market is the Chicago Board of Trade (CBOT), opened in 1865. But similar markets sprang up all over the world hundreds of years ago as merchants, traders, shippers and users of raw materials gathered to swap information. Financial futures have grown rapidly since their development in the 1970s.

What do exchanges look like?

Some, like the CBOT and the London International Financial Futures and Options Exchange (Liffe), are huge, high-ceilinged arenas with octagonal trading pits dotted around the floor. Traders working for banks and investment houses wearing brightly coloured jackets crowd the tiered pits, shouting bid and offer prices to one another in the traditional open outcry method. It can be very noisy and hectic.

Other smaller, newer exchanges trade electronically on computer screens, which display the prices of what is being traded.

What are they trading?

They are trading futures, standardised contracts to buy or sell commodities or financial instruments for future delivery. Futures contracts cover products ranging from pork bellies (bacon) and frozen concentrated orange juice to UK government bonds.

An option gives the buyer the right to buy or sell a certain quantity of a commodity or financial instrument at a specific price within a specific period of time, regardless of the going price. Options on financial instruments, including shares, are especially popular.

Why would anyone use them?

The traditional purpose of futures is to hedge or minimise risk. This involves buying or selling futures contracts as a temporary substitute for a transaction that will take place at a later date.

A wheat farmer in North Dakota planning to sell his crop to a grain elevator at harvest could use futures to protect himself from falling prices. A coffee roaster might sell coffee futures to hedge a forthcoming purchase from Kenyan growers. A City portfolio manager could protect himself against higher interest rates by selling interest-rate futures.

Companies or wealthy individuals might use futures as part of an overall investment strategy. Stock index futures, such as the FT-SE 100 share index, are baskets of shares that provide exposure to a variety of equities and are very popular for this purpose.

Are futures expensive?

If the market goes one way and you have got it wrong, futures can be very expensive. But futures and options enable a company or individual to invest in or hedge a large quantity of the underlying commodity by putting up only a fraction of the cost.

To trade futures, customers must put down margin, like a security deposit, based on the contract size. There are no margins for options.

The values of futures and options contracts vary enormously. One contract of London cocoa futures equals 10 metric tons of cocoa beans, worth about pounds 685 a ton. One contract of German government bond futures is worth DM250,000, or nearly pounds 100,000. Options pricing is more complex.

What about speculators?

In the futures markets, speculation - trying to profit by anticipating price movements - is legal. But market manipulation, as in the famous attempt by the American Hunt brothers in 1979 to corner the silver market in order to push up the price, is illegal.

How can I invest in futures and options?

Many experts in the field do not recommend futures and options for the man on the street. Around 90 per cent of inexperienced investors lose money on them.

Some exchanges recommend that novices start with options, because the option price or premium the customer pays initially is all he can lose. With futures, the risk is unlimited. Exchanges also run introductory courses.

An individual must be an exchange member to trade, or must trade through an exchange member who is a broker. Exchanges can provide lists of reputable brokers who will do business for private clients. Check out a broker recommended to you with the Securities and Futures Authority.

Another way to invest in futures and options is through futures and options funds, set up like unit trusts. British law has only recently allowed them and there are very few available; consult your broker for a list.