In the last of a three-part series on derivatives, Dominic Coyle examines less-familiar but important products on offer to investors looking to hedge their bets on market Markets have fallen in the past three years and the new cohort of equity investors is casting around for other ways to make money ... derivatives have one very obvious attraction - they allow you to make money in a falling market

Covered warrants and spread-betting may be bringing the arcane world of derivatives to the Irish retail investor, but they are by no means the only vehicle open to people looking to hedge their bets on the market.

Until now, however, most derivative products have been targeted at the professional investor - and for very good reason. They are sometimes complex and generally more risky than straightforward stock market investments. This is now changing for two reasons.

First, the 1990s bull market brought a whole new cadre of retail investors into the market. These were people who would never previously have been interested in stocks and shares, either through lack of disposable income or lack of knowledge about how equity investment worked.

In Ireland, the demutualisation of Irish Life & Permanent and First Active, together with the flotation of the State phone network, Telecom Eireann, brought share ownership to hundreds of thousands of people. Some people made money, many more lost out but all became more familiar with the concept of share ownership and, in a bull market, saw it as an attractive investment for their spare cash.

The second factor encouraging the growth of derivatives in the retail market has been the end of the very bull market that encouraged share ownership in the first place. Markets have fallen in value in each of the past three years and the new cohort of equity investors is casting around for other ways to make money on their money. Derivatives have one very obvious attraction - they allow you to make money in a falling market.

Their other attraction is that many are highly geared products where the investor has to pay only a fraction of the full bet upfront, making them more accessible. Of course, this also makes them more dangerous because amateur investors can be caught out by margin calls and quickly rack up losses faster than anticipated. That is why, for all their allure, derivatives will remain, properly, the domain of the more experienced investor.

Take short-selling, for example. This is where an investor sells shares they do not own in the expectation of picking them up at a lower price later to settle their contract. Basically, you are borrowing shares from your broker, one of their clients or another broker.

At some point in the future, you will have to cover those shares - i.e. buy them in the market to give back to the person or institution that has lent them. Sometimes, if there is a big market in a given stock, you can be forced to cover the stock before you are ready to do so because the original owner wants to sell the stock and needs to get it back from you first. This is termed "called away" and though it is not a regular feature of short-selling, it is a risk that you need to be aware of.

Naturally, given that you are only borrowing the shares, any dividends and other shareholder rights remain with the original owner and the short-seller will need to pay them to the lender. They may also face a charge from the broker for the use of the shares.

Short-selling has been in the headlines recently as educational software publisher Riverdeep has struggled to boost its share price.

The company has consistently alleged that it is a target for short-sellers, who are pushing down the price and disseminating negative news about the company to secure a profit for themselves.

In an effort to escape the attentions of these aggressive investors, the company abandoned the more volatile and liquid US Nasdaq electronic market. When that failed, chairman and chief executive Mr Barry O'Callaghan decided to try to take the company private.

That in itself may be one way to frustrate the short-seller. Takeovers, be they management buy-outs (MBOs) or external approaches, tend to send share prices higher - and that is precisely what short-sellers do not want to see.

In Riverdeep's case, news of the possible MBO saw the price leap from 75 cents to €1.55 at one stage earlier this week - well above even the €1.10 level the company had been trading at before its recent tailspin. That's bad news for short-sellers, such as US hedge fund Rocker Partners, which has been betting against the Irish group for some time. If the share price continues to rise or a bid materialises above the expected €2 mark, Rocker stands to lose on its short-selling positions. Of course, if the bid comes to nothing, the "bid premium" built into the current price may disappear, sending the share lower again and cheering the short-sellers.

Short-sellers argue that they are not the vultures of the corporate world. Instead, they see themselves as prescient investors who have the vision to see companies that are heading into trouble and bet against them. These investors maintain that the companies' share prices are heading downward in any case because of problems inherent in the business; the companies themselves insist their prices are being driven down by the short-sellers.

Short-selling is a risky strategy. For every George Soros and his short-selling strategy that "broke the Bank [of England]" there is the short-seller who correctly guessed that the dotcom bubble was just that, but predicted it would burst much earlier than it did. If you get it wrong and the price of the share or other asset rises, your losses may be unlimited. On the other hand, if you're right, the best you can do is win 100 per cent of your bet. For instance, if you short-sell 1,000 shares in Riverdeep at 75 cents, the maximum you can win is 1,000 x €0.75 or €750. However, if the share jumps to €1.55, as it did this week and you have to buy shares at that point to cover your position, you could lose €1.55 - €0.75 x 1,000, which is €800, and the more the price rises the more you lose.

You also run the risk of finding yourself in a "short squeeze". This happens when a company is attracting a lot of short-sellers. With everyone selling the company down, the company itself or another investor may move in the opposite direction, forcing the price up and catching short-sellers unawares.

There is no device in the Irish stock market to indicate which companies are the target of short-sellers or to what extent short-sellers are moving the market. In the United States, the rules are more strict - both on the timing of any such moves and their notification. Short-sellers have to notify stock exchanges of the status of their orders, allowing the compilation of statistics on the number of short-sellers targeting indivdual listed companies.

Choosing a stock on the slide at the right point is risky, even in a bear market. The current downturn has been going on for three years and that has eaten up much of any downside for many equities.

It is worth remembering that the markets' historic trend is upward. Even in the current bear market, there have been four occasions in the past 18 months when the market has jumped 10 per cent.

Get the timing wrong and you are out of pocket.