When buying something in an electronics or appliance store consumers are also asked if they want to buy insurance for their purchase in the form of an extended warranty. Many consider these extended warranties to be way overpriced. Best Buy recently revealed some of their figures allowing us a unique look “behind the curtain”. The important question for us though is how does this relate to buying options?
A list comparing the similarities of insurance to options was displayed. They are both mathematical in nature, they have risk premium built into the price, they have andate and they offer the buyer protection against loss. A list of the advantages of trading options was displayed which included two sided markets in which an individual can be either a buyer or a seller, the ability to , low capital requirements, fair and efficient pricing, and the ability for a high .
Let’s look at an example of a real insurance policy and then compare it to buying put options to protect stock. An example of buying insurance on a $700 camera from Best Buy was displayed. A 2-year warranty for the camera cost $100. Statistically 11% of customers have $100 plus in damages and 30% of customers have $1-$99 in damages. The expected value of buying insurance on the camera came out to a negative $74. An example of the expected value of buying a 20 Delta SPY (S&P 500 ETF) Put was displayed. 15% of the time the Put makes money ($546 on average) and 85% of the time it loses ($135 on average). The expected value of buying a Put came out to a negative $34. A table comparing the results of long 100 shares of stock and long 20Puts to just long 80 shares of stock was displayed. The table included the initial cost basis, Put P/L pere share, new cost basis and total position profit. The table showed for the same initial 80 Delta, an investor was better off just holding less stock.
Options and insurance have a built in edge for the writer to compensate for his risk. This is why we prefer to be premium sellers rather than buyers, to take advantage of the built in mathematical edge that insurers have used to make money since the business began.
Watch this segment of Ripoff: You’ve Gotta Be Kidding Me withand for a fun comparison of insurance to trading options.