If you scan through the back pages of the Financial Times you will find maybe two thousand Mutual Funds that invest in equities, several hundred that invest in bonds or money markets, and a handful that make obscure references to options, futures and warrants. Such oddities are generically referred to as derivatives, because they tend to be derived from a primary investment product such as a stock or a commodity such as gold.

The relatively small number of such funds should serve as a warning that they are suitable only for a few investors. Most of them have a higher risk level than the primary product, and the minimum amount that you can invest in such funds tends to be high. However, for the sake of balance we ought to know what these things are even if we are unlikely to want to invest in them. We'll start with the least complex and work up: Warrants entitle the holder to buy a specific number of shares in a company at a specific price on specific dates. For example, a Henderson Highland Trust warrant entitles the holder to subscribe for one share at 100p on 31st July 1996 to 1999 inclusive. The shares currently trade at 120p; the warrants at 24p.

When evaluating warrants, we need to consider three factors in addition to the merits of the underlying shares: Gearing -- the ratio of the share price to the warrant price. For Highland this is 120/24 equals five. A high gearing means that a small increase in the share price should cause a large increase in the warrant price.

Premium -- the excess of the warrant price plus the exercise price over the share price. For Highland this is (24 100)-120/120 equals 3.3 percent. A low premium means that a small rise in the share price will make the warrant worth exercising.

Time to expiry -- for Highland this is 1999-1994 equals five years. A long time to expiry means that the shares have plenty of opportunity to increase in value before you need to exercise the warrant.

The best warrants are those with a high gearing, a low premium, and a long time to expiry.

For Highland, if the share price increased by five percent a year it would rise from 120p now to 153p in 1999. The warrants would then have an intrinsic value of 53p (we could exercise them at 100p and sell the shares for 153p). So the warrant price has increased from 24p to 53p in five years, or by 17 percent a year.

We also need to be aware of three drawbacks with warrants: They do not rank for dividends. Gearing works to our detriment if the share price falls. They can expire worthless if the share price is below the exercise price on the final exercise date.

Warrants are thus a volatile and risky from of investment. They are similar to long-term call options, and are traded on the stock exchange like shares. In the UK, most warrants are issued by Investment Trusts.

Options are similar to warrants, but last a maximum of nine months. It is important to differentiate between the four ways to invest in options: put and call; buy and sell. If you buy the right to sell a share at a given price at a given date.

Example Ltd shares are trading at $25. A call option at $26 for three months cost 40c. You think the price will fall so you buy 100 put options for $40.

After three months the share price is $23. You exercise your option, selling 100 shares for $2,400 and covering your sale by buying 100 shares in the market for $2,300. Your net gain in $60. Gearing means that an 8 percent fall in the share price has resulted in a 150 percent return on your outlay. Had the share price fallen to $20 your net gain would have been $360. Had it remained above $24 you would have let your option expire; a loss of $40, being the cost of the option. Note that this is your maximum loss, as you have paid for the right to decide whether to exercise the option.

However, had you sold 100 put options at $24, you would have received $40 up front but would then have been liable to buy 100 shares at $24 had the purchaser of the option exercised it. If the share price had fallen to $20 you would realise only $2,000 from the sale of your shares, a net loss of $360. If the share price was above $24 the option holder would not exercise it and you would be in pocket for the $40.

To summarise, buying an option limits your loss to the cost of the option; there is no limit to your potential gain. Selling (writing) an option limits your gain to the cost of the option; there is no limit to your potential loss.

Futures are contracts to buy or sell a standardised amount of a commodity at a set date in the future. They are similar to writing options where the option is always exercised. Example, September gold is trading at $340 an ounce. You buy a contract for 100 ounces, paying a 10 percent deposit of $3,400. In August the price rises to $360 an ounce so you sell your 100 ozs before delivery for $36,000. On settlement, you make a gain of $2,000 on an outlay of $3,400; nearly 60 percent on a six percent rise in the price of gold. Had the price dropped to $320 an ounce you would have lost $2,000. With futures, there is no limit to your potential gain or your potential loss.

Individual warrants can be bought through a broker, but there are several Mutual Funds that invest in a large spread of warrants to reduce your risk.

Options can be bought through a broker, but never write options as the risk is unlimited. Individual futures should not be contemplated. Even Mutual funds investing in futures tend to be very volatile, although your exposure is limited to the amount you invest. Bearing in mind that derivatives are more risky than bonds and equities, you should always seek to limit your risk and should never have more than a small fraction of your portfolio invested in them.

ANDREW R. DOBLE Investment manager, president of Ardent Investment Management Limited