Options: Part 1 Options For Insurance

Introduction
The comments/discussion following my recent Feynman Study Post on the Cluster Weighted
Momentum (CWM) model has prompted me to Post this first article on Options. Options will not be a
tool for everyone and I do not intend for this to become an educational site for Options Trading.
However, there are some situations where it may be possible to enhance portfolio performance, or
reduce risk, through the application of simple Option Strategies.
Most readers, not familiar with Options, may have been told that Options are risky and have heard
comments such as 80-90% of Options expire worthless. While these statements may be true to a
certain degree they are only true due to a lack of understanding regarding the use of Options.

Do you Insure your home?

Do you Insure your car?
Do you Insure your Investments?

I suppose 2 out of 3 isnt bad but arent your investments equally as valuable as your home or car?
Then why arent they insured?
Dont you pay a premium for your home or car insurance and doesnt the policy usually expire worthless
(at least 80-90% of the time)? Do you complain about this? Or are you comfortable paying the premium
for the protection and peace-of-mind that it gives you?
Option Trading can be as simple or as complicated as you want to make it. Im going to stick to the
simple stuff.
First of all there are only 2 types of Options:

Call Options
Put Options

Secondly, these Options can be either bought or sold.

Its almost that simple - but, of course, there are subtleties/alternatives to be considered. Do you have a
deductible on your home/car insurance to reduce premiums?
In this Part 1 I will be considering the use of Options for Insurance so I will only be considering the use
of Put Options.

1. Definition of a Put Option

A Put Option gives the Owner (Buyer) of the Option the right (but not the obligation) to Sell the
Underlying Asset for a fixed price (the Strike Price) before a fixed Date (the Expiry Date).
1.1. The Married Put
Lets take a look at how this might be useful in a situation, as raised by Lowell, where our
Investment method (in this case the Cluster Weighted Momentum (CWM) model) is telling us
that we should invest 100% in VWO.
Page | 1

For whatever reason, we are not comfortable going all-in but, at the same time, we dont
want to miss out on an opportunity if the model is right. There are no assets that are obviously
better to invest in and our other option is to invest less in VWO and keep the balance in Cash.
Unfortunately I cant go back to 8/31/2007 to get Option pricing data for VWO, so Ill assume
the same situation arose today (10/18/2013).
Figure 1 shows todays Option Chain for Options on VWO.

Figure 1 - Option Chain for Jan 2014 Options on VWO with 90 days to Expiry
Lets look at our situation and interpret the information contained in Figure 1.
Assuming our investment model is recommending that we invest $100,000 in VWO this would
mean that we would be buying 2,353 shares of VWO since VWO is currently trading at
$42.495per share. Lets round this down to 2,000 shares (~$85,000 invested) for simplicity.
The Option Chain shown in Figure 1 contains Option prices for both Call Options (on the left)
and Put Options (on the right). We are only interested in the Put Options.
Figure 1 shows the prices of Options for Options Expiring in Jan 2014 (the 3 rd Friday of Jan 2014
is the Expiry Date for these Options), 90 days from today i.e. the Options must be exercised (or
sold) prior to this date. Options are available for other expiry months but I will keep it simple by
focusing on these Jan 2014 Options.
At the left-hand-side of the yellow box are the Strike Price of the Options i.e the price at which
the underlying asset (VWO) can be sold.
With VWO trading at 42.495 lets assume we chose to buy the Jan 2014 42 Put Options. What
does this mean? It means that if we buy the 42 Strike Options we have the right to sell VWO for
$42 at any time before the Jan 2014 expiry date. Thus we have Insured ourselves such that we
cannot lose more than $0.495/share ($990) if VWO falls (no matter how far) below $42 before
Jan 2014 expiry.
Page | 2

However, we have to buy our insurance policy (the 42 Strike Put Options) and, looking at Figure
1 we see these are selling for ~$1.45. One Option Contract represents 100 shares of the
underlying asset, so each contract will cost us $145. Because we are considering the purchase
of 2,000 shares we would need to buy 20 contracts ($2,900) to be fully insured.
We now know our absolute maximum loss on this position if VWO should fall below $42 before
the 3rd Friday of Jan 2014 - $990 loss on share value + $2,900 for the Put insurance = $3,890 or
~4.6% of our $85,000 investment.
If the price of VWO goes up as we expect, then it must go above $42.495 (the price we are
paying to acquire the shares) + $1.45 (the price we are paying for the insurance) = $43.945
before we make money (assuming everything is held until the expiry date). $43.945 is referred
to as the break-even value.
I chose the purchase of the 42 strike price Option because that is the closest to the current
asset price and is referred to as the At-The-Money (ATM) Strike. I wont go into details of
Option pricing here because I want you to absorb the simple stuff first sufficient to say that
the ATM Options are always the most expensive Options to buy.
From the 42 ATM Strike we could consider buying lower Strike, Out-of-the Money (OTM),
Options or higher Strike, In-the-Money (ITM), Options. OTM Option prices are lower and have
no intrinsic (real) value, only extrinsic (time) value since the Strike Price is below the current
asset price. ITM Option prices are higher because they have intrinsic (real) value the difference
between the current asset price and the Strike price plus extrinsic (time) value. Dont worry
too much if youre having difficulty following this last paragraph I only mention these other
terms so that I can explain that what I mean by ATM Options being the most expensive is that
they have the highest extrinsic (or time) value not total price.
Some Investors may choose to purchase a cheaper, OTM, Option such as the 40 Strike this can
be purchased for $0.80 or $1,600 for 20 Contracts. Our maximum possible loss is then $4,990
((42.495 40) x 2000) + $1,600 = $6,590 (or 7.75% of $85,000). The upside break-even is now
lowered to $42.495 + $0.80 = $43.295. This is equivalent to accepting a deductible on our
home/car insurance.
The Profit/Loss diagrams for positions without Insurance and with the Insurance (hedge) of the
40 Strike Puts are shown in Figures 2(a) and 2(b). The red line in Figure 2(b) shows the PNL at
Jan 2014 Expiration, the white line shows the PNL on an immediate change in Price.
The maximum loss and break-even points can be clearly seen in Figure 2(b).

Page | 3

Figure 2(a) Profit/Loss on Un-hedged 2000 share VWO Position

Figure 2(a) Profit/Loss on 2000 share VWO Position hedged with 20 x 40 Strike Puts

Page | 4