In the current market environment, investments dubbed "alternative" or "derivative" are being shunned like the plague. We've all seen the devastation that can come with too much leverage. You only need to mention Opus Prime and Tricom Equities to get people running scared.

But there's more to alternative investing through derivatives than margin lending and contracts for difference. It all depends on your circumstances and whether you really get the hang of derivatives. What's most important is that you understand the reasons why you are investing in a product or venture.

What's on offer?

Different derivative products carry different risks and benefits. There's a lot of choice but, for first-timers, the table above gives an idea of what different derivatives do, what you can trade, whether you can trade over the counter or via an exchange and minimum investment caps.

Two of the most popular are options and warrants. An option is a contract between two parties giving you (the buyer) the right, but not the obligation, to buy or sell a security at a predetermined price on or before a predetermined date. To acquire this right you pay a premium to the writer (seller) of the contract. The ease of trading in and out of an option position makes it possible to trade with no intention of exercising them.

If you expect the market to rise you may decide to buy call options. Call options give you the right, but not the obligation, to buy the underlying shares at a predetermined price, on or before a predetermined date. If you expect a fall, you may decide to buy put options. These give you the right but not the obligation to sell the underlying shares at a predetermined price on or before a predetermined date. Either way you can sell the option before expiry to take a profit or limit a loss.

A warrant gives you the right to buy or sell a certain amount of the underlying commodity at a certain price. Some warrants, such as index warrants, entitle you to receive a cash payment relating to the value of the underlying instrument at a particular time. The key differences between warrants and exchange-traded options (ETOs) are that options terms are standardised and are set by the ASX, whereas warrants are tailored to meet specific needs. Unlike ETOs, you cannot write warrants and there are no margin payments to cover the risk of financial loss due to adverse market movements. There are different types of warrants such as instalment, endowment, barrier, trading and structured product warrants and before leaping into the market you should make sure you understand them all.

Better access

Derivatives also give you access to more markets than retail investors can generally dip into. For instance, some companies specialise in warrants on many different types of commodities, including oil, gold, wheat, live cattle, sugar and cotton. Using derivatives diversifies portfolios.

Many sophisticated investors use derivative products to help them with hedging opportunities to ride out the rough period of the market. Equity and index put warrants allow you to protect the value of your portfolio against falls in the market or in particular shares. Put warrants allow you to lock in a selling price for the underlying instrument. Protecting your position in this way is called hedging. A hedge is a transaction that reduces or offsets the risk of a current holding.

Double-edged sword

Leverage is also a double-edged sword. While it does attract many investors to derivatives, it is also one of the greatest risks because, just as profits are enhanced through leverage, so are losses. Market conditions (for example, currency moves or lack of liquidity) may also increase the risk of loss by making it difficult to effect transactions or close out existing positions.

There are also issuer risks, especially to warrants where the ASX is not a guarantor. With every warrant contract you are exposed to the risk that the issuer (or its guarantor, where relevant) will not perform its obligations under the warrant. You must make your own assessment of the credit risk in dealing with the warrant issuer.

Options writers also face potentially unlimited losses. Writing (selling) options can entail considerably greater risk than taking options. The premium received by the writer (seller) is fixed and limited. However the writer may incur losses greater than that amount. The writer who does not own the underlying shares or does not have offsetting positions potentially faces unlimited losses.

If trading directly in derivatives seems too risky and complicated, you can invest in a fund where professional commodities traders trade on your behalf. You can sell out at any time but it can cost you commissions and fees.

DERIVATIVE PRODUCTS HO WTHEY DIFFER table not availabe on database.