An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk

by Allison Schrager

a financial instrument called a stock option, a contract stipulating you can buy or sell a stock for a certain price within a few months or years, depending on the terms. For example, if you buy a put option, you pay a premium and someone promises you can sell them stock at a particular price in the future. Suppose you buy Facebook stock for $200 a share. You are optimistic about the company’s future but a little worried that it shares stories from dubious news sources, which might pose a risk that the stock price will fall one day. You can buy a put option that gives you the right to sell Facebook for $150 any time during the next six months. A put option offers insurance against the chance that Facebook’s stock price will tank. Here’s another example: If you buy a call option, you pay a premium and someone promises you can buy a stock for a certain price in the future, no matter what the market price turns out to be. Say it’s the day after the 2016 U.S. election. The new president’s preferred method of communication is Twitter, so you anticipate a Trump victory will make it a more valuable company. You think the price of Twitter stock will go up from $19 to $40 in the next six months but don’t want to make a financial commitment to that prediction just yet. You could buy a call option for $2 that guarantees you can purchase Twitter stock for just $30. Six months from now you plan on exercising your option, buying Twitter for $30 and then selling it for $40 and making a n...