The Cutting Room: Demystifying Options

<I>TSC's</I> options guru was shushed when he brought up calls and puts on the TV show. But here, he tells all.
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George Carlin

never mentioned it in any of his great work, but I found out Friday evening that "derivatives" is yet another word that you can't say on television.

Even Richard Babson, the guest on "TheStreet.com" on

Fox News Channel

this week, says he tells his clients to stay away from derivatives. We're chatting in the green room at the Fox studios, and he says he often runs into clients who use derivatives to hedge -- say buying gold futures to protect against interest rate swings -- and the hedge ends up being more harmful than anything else.

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I'll buy that. Too many investors complicate their portfolios trying to mimic what they think the pros would do. But Babson, star columnist

Herb Greenberg

and I are having this conversation a few minutes after the Word on the Street segment of the show, when I discussed getting some protection from any year-end, Y2K jitters by either buying calls or puts on the

Nasdaq

unit trusts that trade on the

American Stock Exchange

, a security called the

QQQ

.

It was typical green-room banter, the kind that goes on while

Dagen McDowell

is getting her hair "fluffed" and I'm stealing from the free cheese tray Fox puts out for the guests. But typically, we'll talk about a specific stock, overall market conditions, etc. But this derivatives stuff seems to sincerely worry Greenberg, likely because he's the kind of guy who cares about investors losing money, a rare and admirable trait amid today's bull market baloney.

I mentioned it once, then apparently made the mistake of revisiting it. Producer

Gary Schreier

was in my ear telling me to cut the jargon and Greenberg was telling me flat-out it was too complicated for most investors to understand in TV time.

I was trying to make it simple, but many options just aren't. Here in a nutshell, is what I was trying to explain:

If you think the Nasdaq has made its move and you're worried about protecting your gains, you can do one of two things: You can buy a QQQ put that would increase in value as the Nasdaq fell or you can sell the stock positions that have been successful thus far this year and replace it with a QQQ call option, which would increase in value if the Nasdaq continued to rally.

I would bet that every red-blooded, self-respecting investor has had thoughts about these very possibilities in the last month, and the options alternatives can be an interesting, effective way to play them for fun and profit.

There are more specifics, but they are for the most part incidental and can be learned by reading

TSC's

Options Forum on most Saturdays and the

Options Buzz every trading day.

Greenberg made the very good point that unless investors really, really understand these investment strategies, they shouldn't get involved. I'll buy that, too. But (and that's a big but) options aren't as complicated as most people think. You make a fundamental decision about an investment and there are two or three ways to play it with the options. And no matter what you do, you tie up less of your capital than you would do it you were buying a stock, then you can take the remainder of your funds and put them in Treasuries or money markets or nice, safe bonds -- and not spend nights tossing and turning about what will happen to your life savings if you (or your broker) is wrong about

Amazon.com

(AMZN) - Get Report

. This is how the smart guys in the market sometimes make money and everyone should be aware that the same plays work on a smaller scale too.

Enough of that, and on to interest rates, which seemed like a key element behind the two stocks Babson spoke about on the show:

Home Depot

(HD) - Get Report

, the store that is to weekend handymen what

TheStreet.com

is to investors, and

Washington Mutual

(WM) - Get Report

, a West Coast savings and loan.

Before the Word on the Street segment, I glanced at Babson's notes -- a skill honed back in high school algebra class I'm ashamed to say -- and mentioned that I loved Home Depot stores.

So does Greenberg, but we both have concerns about interest rates and how Babson's two latest picks will perform in a higher interest-rate environment.

Babson doesn't seem concerned. He likes Home Depot's and Washington Mutual's prospects in any interest-rate environment, and his argument makes sense. These are stocks that can be solid positions whether rates are rising or falling. They, as Babson says, can have it both ways.