Make money from falling shares

By ANDREW OXLADE, COLUMNIST
Updated:

 

THE story of rogue trader Nick Leeson epitomises the popular perception of futures and options - a gamble that can go horribly wrong. Leeson caused the collapse of Barings Bank in 1995 after illegally hiding debts of £850m at the Singapore dealing office.

Now derivatives market bosses want to challenge the view that futures and options are risky, expensive and difficult to understand.

Liffe, the London International Financial Futures and Options Exchange, reckons small investors in the UK are missing out. Individuals have embraced the investments in the US, where retail investors make 60% of trades, and Germany, where the figure is 54%. In the UK it's only 5-10%.

Liffe argues that small investors can use these markets to benefit from falling stocks and thereby hedge risk on their portfolios. Plus there is no stamp duty on individual stock futures.

So what are futures and options? A future is a contract to buy or sell a set number of shares in a company on a certain date in the future at a pre-agreed price. For example, BP shares are, say, 630p and you expect them to fall in the next month. A futures contract for mid-July might be priced at 633p. With £20,000 to invest, you can get exposure to 3,000 shares at 630p by 'selling' three contracts (they are sold in 1,000-share blocks).

You must deposit £2,000 as an 'initial margin', which is necessary to begin covering any losses, and put the other £18,000 in an interest paying account.

Within a couple of days, BP shares fall to 620p and the futures price is at 621p. Closing the position would give you £360: the 9p gap between 633p and 621p multiplied by your 3,000-share exposure. The danger is that if the price went the same amount the other way you would be left with a £360 bill.

Liffe offers prices on 100 stocks listed in the UK, Europe and the US, a FTSE 100 Index Futures, where you must stake £10 per point movement, and a Mini FTSE 100 Index for the more cautious with a £2 stake.

Options, however, are the preferred choice of former vet Val Harrison. The 73-year-old, of Birmingham, says he retired early after turning £2,000-worth of stock market investments into £100,000 over a couple of years in the Seventies. Over the last decade, he has become a big fan of options.

He modestly confessed: 'I'm not a very good stock picker. If I hadn't traded options over the past year, my portfolio wouldn't be down 2% like the Footsie - it would be down 7%. But by selling options it has actually risen 10%.'

An option is a contract that gives the holder the right, but not the obligation, to buy or sell a set number of shares at a pre-agreed price up to a certain date.

When you buy an option you have limited risk and unlimited profit potential. When you sell an option you have unlimited risk and limited profit potential. The reason traders sell options is because the mathematical odds favour the option seller.

You have various choices within options, but Harrison's favourite is to sell the right to buy the shares of companies already in his portfolio. That means you are effectively betting the price will fall. But as a shareholder, you still make gains if the price goes up.

Harrison was concerned about his Standard Chartered bank shares in 1999 so he sold the right to buy the shares on the options market - known as selling a 'call' option. His guess was right and the price fell slightly. He said: 'I would have got a 2.5% return over two years when you include dividends, but I managed to boost it to a 32% return with the premiums from selling the call options.'

If the price had risen, the buyer of the option would have exercised his right, forcing Harrison to buy shares at the higher market price and sell them to him at the lower price. Harrison argues that he would still be up because of his shareholding in the company.

Karl Hughes of Options Direct, a broker specialising in derivatives, warned: 'We've seen people lose their shirts because they thought they knew it all. It's all about managing risk. An advisory service is very important.

Hughes points out that the odds are stacked against investors buying options because 80% of them expire worthless. Options Direct insists on a minimum £5,000 investment for its advisory service.

Jason Hollands, deputy managing director at financial adviser Bestinvest, said: 'We wouldn't encourage our investors to get involved. It means taking a short-term view, which we don't recommend, and a speculative attitude.'

More information can be found on the Liffe website and the Options Direct's website.

Liffe can put investors in touch with derivatives training courses.

Click here to see Val Harrison's fantasy portfolio. He is hoping to ratchet returns to 20% a year with the help of options.

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