For some of you, the title of this article might have raised interrogation. After all, how can anyone compare an insurance company business model to an option writing strategy? On a philosophical standpoint, however, there is a similarity.
The insurance company
When an insurance company insures your car or your home, it collects the premium you pay in exchange of assuming the related risk. By selling insurance to a range of clients, it disseminates its total risk while collecting more premiums. And the more risk a client represents, the higher the premium.
As you know, most insurance companies are profitable and have been around for a long time. We assume this business model is probably sound.
The option seller
What is option writing? It’s collecting a premium in exchange of a market risk exposure. On that basis, insurance companies and option writers do have something in common.
Furthermore, the option seller can manage his risk, comparably to the insurance company. Here are a few insights on how:
· Choosing the strike price: it determines the premium received for the risk involved. The higher the premium, the higher the risk. Just like the insurance company collecting more premiums to riskier clients.
· Technical analysis:an essential tool providing better odds to a winning trade.
· Time decay:as an option approaches its expiry date without being in the money, its time value declines because the probability of that option being profitable (in the money) is reduced. For the option seller, time decay is a friend.
· Rolling options positions:When confronted with big upside or downside swings in the market, chances are the option seller might incur more a challenging trading environment. Rolling options may differ this risk. Rolling means moving the strike price of the option to a more suitable level for the trader. Most rolling positions are done in the front month. If near expiry, rolling to a different strike price of the front month will ensure benefiting from a higher time value. Therefore, rolling an option position when important market swings occur may be a good strategy. Since markets have a tendency to retrace their path after a few weeks of oversold or overbought levels, rolling can become a useful tool to improve risk management for the trader.
These four examples demonstrated the risks involved in options writing can be managed trough different alternatives. Just like insurance companies use their own methods of managing their risk.
When writing options, the premium collected in exchange of a market risk exposure is comparable, in some ways, to an insurance company assuming risk for a premium. From a philosophical standpoint, the two approaches are similar. The next time somebody asks you what is option writing, use the insurance company metaphor. It might simplify a concept too often associated with complexity.