I wrote a few weeks ago that the economics of writing options (i.e. selling options that you intend to let expire or buy back at a lower price) are a lot like those of an insurance company. Yes, there are risks, and insurance companies do take losses from time to time. But those risks can be managed, and — let’s face it — insurance company failures tend to be extremely rare. So long as people are willing to overpay to protect themselves from disasters, insurance will be a profitable business model.
Well, my friend and colleague Lee Lowell picked up the torch and took those comments a little further last week in the Rich Investor. Below is an excerpt from his article. Enjoy!
How to Pull in Cash Just Like an Insurance Company
by Lee Lowell
Do you ever think about all the money you pay to insurance companies each year? I wouldn’t blame you if you didn’t.
I mean, there’s car insurance, home insurance, renter’s insurance, life insurance, medical insurance…
It adds up. We just assume that’s part and parcel of living in the modern world, so we grin and bear it.
Fact is, I’m pretty sure that in your lifetime, you’ll never make a substantial claim from your insurance company. (Here’s hoping!)
Sure, you might get into a minor fender bender or have a leaky roof that can cost a few thousand dollars to fix. And, if that happens, it’s almost a guarantee your premiums will go up.
You’ll fork over even more to your insurance company each year.
But where does all that money go?
Right into the insurance companies’ pockets, and whatever’s left over heads to their shareholders.
Again, insurance companies are insuring you for things that almost certainly won’t happen. They’re banking on low-probability events, and they’re raking in the cash.
I was thinking about insurance when my colleague Charles Sizemore recently answered a question from one of his Peak Income subscribers.
The reader asked Charles’ opinion on whether the timing was right to start buying put options on the Dow Industrials.
Here’s how Charles replied:
As a general rule, I don’t buy options because they’re too speculative for my style of trading.
Due to the time decay of options, you have to get the timing just right to make money buying call or put options.
Some investors choose to buy put options as portfolio insurance. As a general rule, I do not.
I think about it like this: I buy homeowners insurance because my house is a large piece of my personal net worth, and I have no other practical way to hedge the risk of a disaster.
The insurance is expensive, and I hate paying it. It irks me that my insurance company profits off of my fear.
But, again, I pay the insurance because I don’t really have a choice.
Portfolio insurance is different. I have choices.
If I’m worried about a market crash, I can set a stop-loss or simply sell some of my stocks and raise cash.
I don’t need to buy expensive put options that will nearly always expire worthless.
But while I don’t buy put options, I do often sell them.
If done correctly, selling out-of-the-money put options can be a conservative income strategy. Rather than paying insurance premiums every month, I’m more like the insurance company that collects them.
Charles hits the nail on the head.
Over the years, I’ve seen this same question and given the same answer many times. Charles also echoes everything that I’ve been writing in these pages so far in terms of selling put options.
Remember: Insurance companies are insuring you for things that almost certainly won’t happen.
That’s the secret sauce!
But, as Charles says, he pays it because he has no choice.
And that’s true. We have to pay it, right? We just can’t take the chance of being without it if disaster strikes.
What if you could turn that dynamic on its head so that it’s you collecting cash?
I’m here to tell you those same principles are at play when you sell out-of-the-money (OTM) put options – and doing so can bring in lots of money in the process.
How so?
When you sell an OTM put option to someone, you’re collecting their premium upfront (just like insurance companies) while offering them insurance against an event that most likely won’t happen – specifically, a very large fall in the stock price.
But as long as the stock doesn’t fall to the put-option’s strike price (a very unlikely occurrence), you keep the whole premium at expiration.
Take Amazon (AMZN), for example.
It currently trades at $1,880 per share. I recently wrote about how you could get paid upfront premiums – and keep them – as long as Amazon doesn’t fall to $370 per share.
The odds of that type of fall happening? Practically nil.
Still, someone who owns the stock is looking for some kind of insurance against it falling in price, even all the way down to $370.
How do they do that? They buy a put option that allows them to sell the stock to someone else at a price of their choosing.
It’s peace of mind for them. So, they buy the insurance.
Who’s the insurance company in this case? The put-option sellers! Put-option sellers offer the insurance and collect the premiums. And they can do this year-round.
The key to making consistent money from this strategy?
By deciding where the stock is most likely not going to fall to.
It’s a much different concept to ponder. Most stock and option buyers are always trying to figure out where the stock is going.
But put-option sellers are basing their trades on where the stock isn’t going. Huge difference, and the odds are well more in their favor.
Better yet, you can sell these sorts of options on hundreds of stocks each month and collect thousands of dollars in the process.
The key is picking an area where the stock has such a low probability of falling. That’s how you decide which put option to sell.
You’re in complete control. You choose the stock and you choose the strike price level.
But how do you know where a stock most likely won’t fall to?
You do your research just like any other investor. You look at stock charts, you check the stock’s fundamentals, and you use a secret weapon like a probability calculator.
Pick a point where the stock has very little probability of falling to. And then sell the corresponding put option. You’ll collect the premium and if the stock doesn’t fall to that level by expiration, the money is yours free and clear. Wash, rinse, and repeat!
And what if the stock does in fact fall to the level by expiration?
Well, this might be the best part – if you picked a high-quality stock to begin with, that means you’re scooping it up a ridiculously low price. Can you imagine getting your hands on Amazon for $370 a pop? Do you think it’d stay at the level for long?
My best advice for anyone wanting to sell put options: only execute this strategy on stocks that you feel would be great to own at below-market levels.
That way, if you do in fact end up owning the stock, it’s still a win!
In short, stick to your favorites, and stay the heck away from companies you don’t care about.
When you concentrate on selling put options on levels where the stock won’t fall to, you’ll see your win rate skyrocket.
This is how the insurance companies play the odds. It’s about time you did, too.
This first appeared on The Rich Investor.