Warren Buffett, "Oracle of Omaha, is well known for his preference for insurance companies.
Insurance companies provide a steady source of income in the form of premiums while also allowing Buffett to invest the funds collected from those premiums. The float created by the insurance business provides a large pool of low-cost funds that he can use to invest in stocks, bonds, and other securities, generating additional returns for him. In addition, insurance is typically less volatile than other industries, providing a more stable investment opportunity.
Thus the insurance industry provides a great model for low variance, cash-positive returns, and returns that are not correlated with the stock market. But, of course, actual insurance companies are out of the reach of most individual investors. Though what if the business model is not? What if you could replicate those same business principles using options?
We have already addressed the trade-off between high returns vs. low variance for most investors. What if I tell you that it is possible to use the insurance industry as a model to construct a low-volatility, non-correlated investment strategy using options?
It is. I like to think of selling Puts as selling insurance.
An Option Contract and an insurance policy are very similar. Just as insurance protects your car from accidents, a PUT option protects stock from market crashes.
The premium is the buyer's cost for the protection the contract offers. For a PUT option, the buyer pays a premium for the right to sell a stock at a predetermined price, the strike price. Similarly, when buying car insurance, the premium is the cost the buyer pays for the coverage offered by the policy.
Both contracts have explicit rules regarding the outcome should an incident happen. For example, who will pay if the car gets totaled or the stock falls below the strike price? So, both contracts have specific conditions for the buyer to exercise their rights and receive compensation. In a PUT option, if the stock falls below the strike price, the buyer has the right to sell it at that price, limiting their loss. Similarly, in the case of car insurance, if the car is involved in an accident and is deemed a total loss, the insurance company will pay the sum stated in the policy. These clear rules and outcomes provide certainty and peace of mind for the buyer, as she knows precisly what to expect in the event of an incident. This clarity makes the stock option and the insurance contracts valuable tools for managing risk.
Risk is inherent in life and can manifest in various forms, such as financial, physical, or personal risks. For instance, when buying an insurance policy for your car, you are transferring the risk of potential damages or losses from yourself to the insurance company. The insurance company agrees to take on the risk in exchange for the premium.
Michel Lewis says, "Risk, I had learned, was a commodity in itself. Risk could be canned and sold like tomatoes."(*).
I like this concept of risk as a product that can be packaged, bought, or sold like any other product. Like how we buy and sell goods in the supermarket, risk can also be bought and sold through various financial instruments such as insurance policies or derivatives. These financial products allow individuals or companies to transfer or manage their risk by transferring it to another party willing to take on the risk in exchange for a payment.
So by selling options and collecting premiums, you are, in fact, buying risk. You are getting paid for helping other people sleep well at night.
When you buy risk, you will always collect your premiums.
The insurance company will only pay out when there is a tempest or an accident. Likewise, you will only pay when the stock price drops significantly.
So naturally, the odds of paying are not that high.
But what are the odds? Are the rewards sufficient to cover the risk I'm buying? Is it worth it? How do I put tangible numbers to evaluate that business potential?
The key to making a profit for the insurance company is correctly estimating the probability of accidents and other incidents and pricing policies accordingly. Then, by charging a premium higher than the expected cost of claims, the insurance company can generate an underwriting profit. If the company's calculations are accurate and the number of incidents is in line with expectations, the company will be able to earn a profit and maintain financial stability.
In sum, insurance companies make money by correctly estimating the probabilities of future events.
But how can an individual trader determine the probability of the Apple stock dropping by $15 over the next 60 days? Our next article will make a slight detour to the race track to answer that question.
We find the best option strategy to trade Microsoft [Backtest study]
Advantages of trading options vs. traditional stock trading
We backtest an options trading strategy to observe its real historical performance and discover a true winner using the eDeltaPro Options Backtesting Software.