In my recent article, I introduced you to the concept of using options as a way to manage risk in a trade.
THE BASICS
As a quick recap there are two types of options:
Call option – Gives the buyer the right to buy a stock
Put Option – Gives the buyer the right to sell a stock
As an investor buying calls or puts can be used to insure your position (better said: hedge) against a sudden unexpected move that is not in your favor.
WHAT ABOUT SELLING THE OPTIONS?
Most students I work with understand the idea of buying options as insurance; it’s not very hard to understand after all. But they struggle to see the value in selling options. Think about it: If you buy a put option to protect yourself in the event of a market turning down against you, who in their right mind would sell you that option and take your risk?
The answer is a Stock Insurance Salesman! Okay, this person does not really exist but in function that is exactly what is happening. The person who sells a put option sells the buyer (let’s assume you are the buyer) the right to sell that stock in case the trade goes bad. That means the option seller has become obligated to buy the stock when the market gets bad! So why would they do this trade?
IT’S LIKE HOMEOWNERS INSURANCE
The same reason State Farm or Nationwide or any other insurance company sells you homeowners insurance. Think about it: If your house burns to the ground all you have to pay is your deductible – everything else is the responsibility of the insurance company. If the house is a total loss they will likely buy you out of your house and they are now the owners of a worthless, burned to the ground, house. That sounds stupid right?
Unless you have run the numbers and realize that most houses don’t burn to the ground! An insurance company collects premiums from their entire customer base and most of those insurance contracts expire worthless. At the end of the year (or however long the policy is for) the insurance company renews it, collecting the premium again. Multiply that times thousands of policies and you have quite the income.
Now what are the odds that all of your houses you have insured will burn down? Very low. And that is how an insurance company makes money.
Let’s now do the same with stock. Imagine you are in a bullish market. If you buy a stock what are your odds of making money? The answer is 33%. The stock could go up, down or sideways – and yes sideways is a losing position because you pay for commissions and opportunity loss.
Now what if you were to sell a put option to an investor giving them the right to sell you the stock if the market goes down? Well if the market goes up they will never sell you the stock for less. If the market goes sideways they will want to keep their stock and you will not need to buy it. That alone gives the option seller twice the odds – boom 66% chance of making your profit.
SELL INSURANCE AND COLLECT PREMIUM
And what happens if you did this trade over and over and spread it over many stocks? Well you would be functioning in the world of trading as a stock insurance salesman. You are selling insurance and collecting policy premiums.
And that is how you start a stock insurance business.
Stay tuned. In my next article I will teach you how an insurance company lowers their risk in the event the whole city burns down!
