Welcome to the Demystifying Options Series

The series will be informative, educational, and may even lead you to trading options. I will be using insurance analogies in order to help with relaying the concepts. The articles in this Demystifying Options series will be released on a weekly basis so stay tuned.

My name is Todd, I am currently the Director of Options at CTS (Cunningham Trading Systems) and Co-Lead Developer of CTS’s Options Pro trading and analysis software. I have a seat at the CME, I was a floor and electronic options trader for 20 years, educated hundreds of new and veteran traders for 15 years and consulted for several traders, firms and clearing firms for 11 years. I will bring all of my knowledge, expertise and experience to this series, which I hope you learn from and enjoy!

 

What is an option?

The easiest way to explain “what is an option” is through an analogy. Insurance is a good analogy and will help to bridge the gap with some unfamiliar concepts.

So would you like to be the insurance company or policy holder?

Well, you can be the insurance company and/or policy holder via options. Try changing the word “option” to “policy.” If you want to be the insurance company (policy issuer) you get short (write) options (policies) by selling. If you want to be a policy holder (purchaser) you get long options by buying.

So if you are the policy issuer (short options) you receive the cash (aka premium) up-front in exchange for the risk associated with the policy (option). If you are the policy holder (long option) you prepay the premium in exchange for the right to exercise the policy and the protection.

Insurance companies and most options traders diversify their portfolios. Meaning they try to limit risk and have different risks. Insurance companies have policies that are of different risk types and time frames in order to diversify. Option traders do the same thing but they have one large advantage: they can choose to act like the policy issuer, policy holder, or as both.

So an option is an “insurance policy” that lets you participate as the policy issuer or holder.

 

Are options just insurance?

For the most part, YES. They are very, very similar.

You know insurance well enough to understand that a policy issuer and policy holder both have rights and obligations. For the most part the issuer’s rights are the holder’s obligations and the issuer’s obligations are the holder’s rights.

As a policy holder of insurance you have certain rights and obligations. Your obligation is to choose the correct level and type insurance product for what you are trying to protect and pay the premium in order to maintain that protection. You have the right but not the obligation to exercise your policy (file a claim). You are not forced to file a claim. This is exactly the same as an option buyer.

As a policy issuer you also have certain rights and obligations. Your right is to receive the premium of the policy. Your obligations are offering different types of insurance policies, pricing the premium on each, and if the policy holder exercises their right to file a valid claim then the policy issuer has to pay the policy holder. This is very similar to an option seller (we’ll get back to this).

 

So why buy options?

The answer is simple: you want to be insured against something you do not want to happen.

You have a limited risk. Just like any policy holder the maximum risk is the premium you paid.

Your reward is not as simple of an answer. As a policy holder of insurance there is a limited amount of money you receive from a claim. But being long an option (option owner) you have the potential of an unlimited reward.

In terms of insurance let’s say that the annual premium to protect your car is $1,000 and the value of the car is $30,000. Now let’s look at a couple of scenarios. If your car gets stolen then the insurance issuer (policy seller) gives you a check for $30,000. But remember you paid $1,000 for $30,000 of protection, netting a “reward” of $29,000. Ok so it is not really a reward but at least you can get a car. If you get in an accident and the damages are $10,000 you only net $9,000 since you already paid the insurance company the premium. If you don’t have a reason to file a valid claim you lose the $1,000 premium.

In term of options you can buy a “policy” (long option) for $1,000 and if the value of that policy increases your profit would be the value of the policy less the premium. So if the value is $50,000 you would net a profit of $49,000. If the value of the policy ends up worthless you just lose the $1,000.

 

So why sell options?

It does seem odd that anyone would want to take a low profit potential and accept a large potential loss, yet insurance companies always accept these terms. Why?

The reason has to do with risk adjusted premium. The basic concept is the insurance companies use the probability, amount, and frequency of the loss versus the premium.

Here is a game of wagering that explains the concept of risk adjusted premium. It is based on changing the premium to account for the probability of outcomes.

The game is between two people. Let’s call one person the “insurance company” and the other the “policy holder.” They have a die with three sides. The first side has the letter A, the second has the letter B, and the third has the letter C.

The policy holder says “I will bet that the letter B will come up when I roll the die and if I win I want $5.”

The insurance company says “I accept that bet but if you lose you pay me $????” You can see that the insurance company has not yet stated the amount of money the policy holder will need to pay if they lose.

 

Probability Adjusted Profit

So here is how the insurance company can come up with the value of the premium. Since no one can predict the result of the die with 100% confidence, probability needs to be used.

First the insurance company needs to determine the probability of losing and winning. This is determined by “desired outcome(s)” divided by “all the possible outcomes.” The insurance company loses if the letter B comes up and they win if A or C come up. The probability of the insurance company losing for a single roll is 1 in 3 (1/3 = 33.3%) and the probability of them winning is 2 in 3 (2/3 = 66.7%).

Next the insurance company needs to calculate the loss based on probability of losing. So they take “probability of losing” times “amount of loss” equaling the “Probability Adjusted Loss” (33.3% x $5 = $1.67). Now the insurance company knows their probability adjusted loss is $1.67 given the probability of losing is 33.3%.

Now the insurance company needs to risk adjust the wager so they can make money based on the probability. Let’s say the insurance company wants to have an expected return of $1 every time they play the game. If you subtract the “Probability Adjusted Loss” from the “Probability Adjusted Profit” you get the “Expected Return” for each time the game is played. We know that the “Probability Adjusted Loss” is $1.67 and the insurance company expects a profit of $1, so add the $1.67 and $1 to get $2.67 which is the “Probability Adjusted Profit.” Now the insurance company knows that their probability adjusted profit needs to be $2.67 given the probability of winning is 66.7% in order to make a $1 expected return.

But they still need to tell the policy holder how much to wager! So the insurance company will take the “Probability Adjusted Profit” divided by “probability of winning” equaling the “wager” ($2.67/66.7% = $4.00). Ah… finally the insurance company can finish the statement “I accept that bet but if you lose you pay me $4.00”

 

Here is the game’s summary

The insurance company wanted a smaller amount of profit but was willing to pay out a larger amount.

The policy holder wagered $4 with a lower probability to make $5.

If the game is played 3 times with a different result each time (A, B, C) then the insurance company collects a total of $8 and pays out a total of $5, netting their desired average profit of $1 per roll.

Did you understand all that? If not, no big deal. Just remember this one thing: a higher probability of loss should equal higher premiums (wagers).

 

Read the next article, ”Option Time,” coming soon.

 

Written by Todd
Director of Options at CTS (Cunningham Trading Systems)
Co-Lead Developer of CTS’s Option Pro trading and analysis software
Feel free to contact me at [email protected]