Comparing an option to an insurance policy can many times help to simplify your learning curve when it comes to options.
What is an option?
“An option is a financial derivative that represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date)” as defined by Investopedia.com.
Some Essential Characteristics of an Option…
- The total cost of an option, which is also known as the premium, is determined by the price of the stock, the time which remains until expiration, the strike price, and the volatility.
- If you buy an option, you are known as a holder of an option. If you sell an option, you are known as a writer of an option.
- When you buy an option you have a right, but you are not obligated, to do something with the option. You can allow the option to expire, or you can choose to close out the position before expiration.
- An option is a depreciating asset. It has a limited life, due to the date it expires. All options expire at a certain point in time.
- Options are regulated by security laws and regulations.
- When you buy an option you have a right, but you are not obligated to do something with the option. You can allow the option to expire or you can choose to close out the position before expiration.
What is an insurance policy?
The definition of an insurance policy as stated by www.businessdictionary.com is as follows:
“A formal contract – document issued by an insurance company to an insured. It puts an indemnity cover into effect, serves as legal evidence of the insurance agreement, sets out exact terms on which indemnity cover has been provided, states associated information such as the specific risks and perils covered, duration of coverage, amount of premium, mode of premium payment, and deductibles if any.”
“Insurance is a means of protection from financial loss. It is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss.” as defined by Wikipedia.org.
Some Essential Characteristics of an Insurance Policy…
- Let's say you buy an insurance policy. You pay a premium to the insurance company for this policy which you purchase.
- The insurance company is the seller of the contract. They are the writer of the contract.
- You are purchasing the policy to protect yourself from a sudden event. If a month goes by and you do not place a claim to use your insurance policy, the insurance expires and the insurance contract becomes worthless. The insurance company keeps the monies you paid for the policy.
- The policy protects you for one month.
- If you have a problem which the insurance policy covers, you would make a claim and receive monies from the insurance company for the policy you purchased.
- An insurance policy can be priced according to location, the amount of coverage, and the amount of insurance.
Options' Similarities to an Insurance Policy…
- You can buy an option to create a hedge on an existing position. The hedge is there to protect your position, just like an insurance policy.
- You can purchase as much insurance as you need to protect your home, for instance. It is the same with an option… you can purchase as much protection as you think you need.
- You can be similar to an insurance company by selling an option. When you sell the option, you collect the premium from the sale of the option. When you sell the option, you are the writer of the option. As long as the option performs according to your plan when you sold the option, you would keep the premium for a potential profit.
- As the option gets closer to expiration, in most cases it will begin to depreciate in value. This is once again very similar to an insurance policy. As each day passes, you are using up some of the premium you paid to the insurance company. Options have limited life, just as an insurance policy. They expire at a certain point in time.
- Pricing of insurance is based on location, time period of the insurance, and the amount of insurance. This is similar to an option's pricing which has a time factor, the strike price or location, as well as the expiration date. If a property is being insured and it is located in a flood zone, tornado or hurricane zone, the property is in a volatile zone. The insurance policy will cost more. This is similar to an option pricing when volatility is taken into account.
As you can see, options in many ways are similar to an insurance policy. If you are just getting familiar with options, it can be helpful to think of options in this way to simplify the learning curve.
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Feel free to comment below if you have additional thoughts relating options to an insurance policy.