by Ken Kurson Published August 11, 1997 Nobel-winning physicist Neils Bohr kept a horseshoe above his desk. A visitor once remarked, "Surely a level-headed scientist such as yourself doesn't believe a horseshoe will bring you good luck..." "Of course not," said Bohr, "I would never believe such foolishness. However, I am told that a horseshoe will bring you good luck even if you don't believe in it." In other words, always hedge your bets. An option is exactly what it sounds like: it gives its buyer the option, but not the obligation, to trade something at a certain price on a certain date. A "call" is an option to buy an asset, while a "put" is an option to sell an asset. With stock options, each option corresponds to 100 shares of the underlying stock. Here's how it works. Let's say Coca-Cola is trading at 70 and you think it's going higher. You purchase one 3-month Coca-Cola call at 75. Three months pass. If Coke has risen past 75, you're said to be "in the money." Let's say Coke has climbed to 80. You can exercise your right to buy 100 shares at 75 then sell them right away at 80 — a quick $500 profit. Puts work the same way, except they reflect a bearish outlook. The put buyer thinks the underlying security is going down and wants the right to sell the security at a certain price, which is called the strike price. If Coke's at 75 and you buy a single 3-month put at 70, you're going to make $500 if Coke's at 65 when you exercise the put. In actuality, options buyers seldom actually exercise the option by buying or selling the security that underlies it. The way they make their money is by reselling the option. Say Coke's at 70 and you buy a 3-month call at 75. The day after you buy the call, Coke goes to 80. Rather than exercising your option and actually buying the 100 shares of Coke, you just sell your call to another investor. Obviously, the fact that it's now at 80 makes your right to buy it at 75 more valuable than when Coke was trading at 70. So what's the downside? First, there's the real good chance that Coke won't rise higher than 75 by the time the option expires. In that case, your option is worthless. Second, it costs money to buy the option. That money's called the premium. There's a relationship between the perceived likelihood of the option to get in the money and the cost of the premium. Using the Coke example, a three-month call at 79 would cost more than the three-month call at 80; and a three-month at 80 would cost less than a 6-month at 80. Let's say the 3-month Coke 80 call you bought cost you $250. If Coke goes to 81, you're in the money to the tune of $100. But since the option cost you $250, you're actually out $150. Coke would have to rise to 82-1/2 for you to break even. continue with © 1997 Ken Kurson, All Rights Reserved