Hey everyone, Kirk here again at optionalpha.com and welcome back to the daily call. On today’s call, I want to talk about the striking similarities between options trading and insurance. I love talking about this, honestly. I think it's just honestly one of the best analogies that we can use to help educate people on how to trade options, why we do what we do, like why we setup our trades the way that we do, our portfolio the way that we do, we position size the way that we do and the edge that we’re trying to take out of the market. I think there are so many similarities between this and it’s obviously evident that generally, this stuff works because not only does Warren Buffett have huge stakes in insurance, but he’s also a very big-time option seller. He talks openly in his 10Ks and 10Qs for Berkshire Hathaway about the edge and implied volatility, the overstatement in implied volatility, all this stuff. You guys can all read about it. It’s all public information.
When I think about the insurance business… I’ll try to take this in probably the most extreme version in every case because I think it really drives home the point. But let’s say that I want to start an insurance company and I want to ensure people from their houses burning down. If I were to start this insurance company and ensure one person, literally my insurance model was that I was going to ensure one single person, I would ensure your house maybe for $500 a year, but if your house burn down, I have to pay out $300,000. Maybe that’s the value of your house if it burns down. Well, if you think about that, that’s a really terrible business model. One, because all of your eggs are in one basket. I’d probably just park out of your house with a fire truck and make sure that under no circumstances does your house burn down. There would be no electricity, no fires, no fire places, etcetera. You are watching and monitoring that basket so much, that house so much because it is literally your only asset and your biggest liability at the same time. But this is how most people trade, honestly if you think about it. They have one or two really big positions, they really don’t understand them and they spend all of their time watching them and monitoring them, hoping that it just doesn’t burn to the ground. Really, that’s what happens because we can’t control anything in the options market any way, just like we can’t necessarily control that somebody falls asleep with a cigarette and burns down their house. We can’t control that stuff if we’re running a business.
But in the insurance market, what they do to alleviate that risk or to reduce that risk is they write insurance policies on hundreds of thousands of homes every year. In fact, every home that they write an insurance policy on reduces the portfolio’s risk of any one single house burning down and basically collapsing the business. Again take my new insurance business that I say I’m physically starting which I’m not doing, but you know what I’m saying, like that’s the point here. But let’s say now, instead of just writing insurance policy on your house for $500, let’s say I do that on 100 houses for $500. Now, my risk is spread across 100 houses. Now, I don't necessarily need to park outside of your house with a fire truck, making sure that your house doesn’t burn down. I have the ability now to spread my risk across 100 houses. Now, this still probably isn't the best case scenario, but it’s obviously better than just writing insurance policy on one house.
Insurance companies recognize this and that’s why they not only just limit the amount of insurance that most people can get, (that’s something that you often see) but they also diversify their portfolio of potential liability across different things like different houses, different states, different types of houses. Then they also have started filtering in and they did this long, long time ago, this wasn’t like a new thing. But they started filtering in insurance on cars, insurance on life, insurance on your disability and your workability. There’s all these different things. And the reason that they do this… Like really think about this. The reason that they do this is because no one single person, house, car, life, etcetera is going to collapse their business. It's never going to collapse their business. Your house burning down or their house burning down or somebody getting in an accident or somebody dying, somebody getting disabled at work is not going to overall, collapse their business. They’re generating enough cash flow from everything else to cover that potential windfall I guess or loss that they have. Now of course, that loss is always going to be bigger than the initial premiums that were collected, but over time, all of the premiums end up paying for more than that potential loss could be and that’s where we see this edge start to play out.
When we talk about edge now, in the insurance market, what they do with actuaries is they actually calculate the probability of your house burning down or you dying or whatever the case is. Like whatever they’re ensuring, they have actuaries that calculate based on hundreds of thousands of people in that same situation or with that same disease or that same make up, you’re 45 years old, a male, non-smoker, whatever the case is. They have actuaries that calculate all of these probabilities of your actual likelihood that you, a guy get disabled, your house burns down, you get into a car accident, etcetera. When they have that probability, than they price in a premium over that. That’s really about as simple as their business becomes. If your probability of say dying is 1%, not to get more of it here… But let’s say the probability that your house burns down is 1%, then they price in their policy, the likelihood that your house actually burns down, 2% and they calculate how much money they would need to collect if your house burns down 2% of the time over hundreds of different contracts and people's houses that they ensure that are just like yours, how much money would they need to collect, so that if 2% of their houses burn down, they have enough money to pay for those houses, plus generate a profit. That is the insurance premium that they price in. In the options market, (and if you understand that which hopefully you do) that premium is the implied volatility premium. That’s the implied volatility premium that is priced into an option contract, this expectation that the stock moves more or moves higher or lower than it actually does in the future.
The insurance market example: If the insurance company prices in the probability that your house burns down at 2% of the time, then they know that generally, it should burn down 1% of the time over hundreds of houses that they ensure hundreds of years. 1% of the time, the house burns down. Now, they’ve made an edge, a 1% edge in all of their contracts across all houses that they ensure. Again, that doesn't mean that your house won’t burn down. It just means 2% of the houses or less will burn down and they’ve priced that in. Same thing in the options market. The options market prices in with implied volatility that the stock might move let’s say 10% up or down over the next month. We know from our research from… You can look up other research from numerous other places that the stock might only move 8% up or down. It never moves as much as the market assumes it’s going to move on average long-term. It doesn’t mean that a stock can’t move more than 10% in one month. It’s just on a consistent basis, is it doing that over and over and over again. And so, that's the main major overarching similarities between insurance in trading that you have to understand because they’re very much the same business, just in two different arenas.
Again, the last and maybe the last point here is that if we glaze over this originally, but it’s important to come back to, is that for all of this stuff to work, you have to understand that no one single contract, ETF, house car, person’s life, etcetera can collapse your business. If you understand that, meaning you have to spread your risk across multiple avenues, multiple securities, multiple industries, then you have to understand that each one of those positions has to be small in nature because here's what you don't know and what insurance companies don’t know either. They don’t know when that event is going to happen. They can’t tell you when you're going to die. Nobody can tell you when you’re going to die. They can’t tell you when your house is going to burn down or when somebody is going to run into you and you’re going to get a car crash, just like we don’t know when a stock is going to crash up or crash down. We don’t know that. You don’t know that either. Stop guessing when that’s going to happen. Just start playing the probabilities, start playing the mathematics behind it because the math is what it is. You can’t fudge the math. If you have one insurance contract on one house and that house burns down, you’re out of luck, you’re out of business, so don’t do that. That’s just simple math and understanding of how markets work and how portfolios work. Hopefully this helps out.
I know I kind of rambled on here a little bit, but I think it’s really, really important that you guys understand and take the time to understand these overarching things. It makes everything else so much more clear, so much easier to implement if you understand these basic mechanics. Hopefully this discussion about the similarities between options and insurance helped out. If you have somebody who has maybe struggled that you know of, a friend, a coworker, etcetera, somebody in your family that’s trying to learn options and they don’t really quite get it or what you’re trying to do, maybe this is the podcast that you send to them before the end of the year here and show them what to do, show them why you’re doing it, help them understand, teach them. If you teach them, it helps reinforce these concepts in your own mind which obviously helps out. Until next time, happy trading!