Drawing Comparisons

An Option, in essence, is the same as an insurance policy since there are many similarities in the way they work. Traders who are new to options trading should first try to understand what an insurance policy is because it will help them later on when thinking about an option contract in the same way.

The basics of an insurance policy:

A person who takes out an insurance policy (the insured), does so to provide a guarantee against something happening to them. The person or company who underwrites that contract (the insurer), on the other hand, takes all the risk in order to guarantee the insured against the risk of something happening. The insured therefore pays a premium to the insurer for the guarantee that he/she gets.

When the day comes that an insurance policy expires and the insured never realized any risk, then the insurer gets to keep the premium paid, because he/she was willing to take on the risk.

But, in the event that the insured was to realize risk during the life of the contract, then the insurer would need to fulfil his/her obligations and pay out money to the insured.

That, in a nutshell, is how insurance works, it is a simple business.

Consider the following examples: 

If you were a producer, of let’s say corn flakes, then the price of your product in the market place will be more or less stable and would not fluctuate daily. The price of your raw material – corn in this case – does fluctuate daily and you would probably be fine up until a certain price, but if corn prices were to rise above that price, then your business could become unprofitable.

So, to protect yourself against a sharp rise in Corn prices you could ask for a guarantee against price exceeding a certain level and to get that guarantee – someone may be willing to sell you an insurance policy to protect your business. Depending on what price level we are talking about here, that insurance policy will, in turn, cost you a certain premium. You would, therefore, need to decide whether you are willing to pay the premium required or not.

If you were doing business with an overseas company then you would be exposed to the fluctuations of Currency Exchange Rates. It would then make sense to insurance against the currency exchange rate going over or below a certain Exchange Rate.

If you were in the commodity production sector – like a mine producing Coal, Gold, Silver, Copper, Nickel or whatever, then you would need to sell your product at a certain minimum price and if price dropped below that level you would become unprofitable, you would like to insure yourself against the price of your commodity dropping below a certain level.

These are all examples of insurance policies and these policies are available, at certain premiums.  They are not however called “Insurance Policies” when it comes to trading they are instead called “Options”.  There are policies designed to protect you against RISES in prices, also known as CALL Options, and policies designed to protect you against prices FALLING, also known as PUT Options.  They are just two different kinds of insurance policies.