Lesson 1 Question What is the main concern you should have when you buy a stock? Answer You could lose all of your money. Question Is there a way to insure myself against substantial loss? Answer Yes. I could purchase a Put option contract to limit my loss.
This is where we will start our business venture. We will be the insurance company for the stock investor introduced above.
These are real live numbers as I am writing this blog. Stock price $132.23 X 100 shares = $13,223 Sell a Put $1.46 X 1 contract = $146. $130 Strike price. 22 days until expiration.
The stock investor will insure her $13,223 investment for 22 days by paying a premium of $146. Her maximum loss will be limited to the Put premium of $146 plus the difference between her investment of $13,223 and the $13,000 she will receive if the stock falls below $130 per share. $146 + $223 = $369 maximum loss plus the commission she has to pay for this insurance.
Question What is my risk as the insurer? Answer The difference between the $130 I guaranteed her if the stock should fall below that amount and $0 if the stock would be worth nothing in 22 days. I could lose $13,000 for a $146 gain which is .011%. Pretty risky. Question Could I offload some of this $13,000 risk to someone else by buying insurance? Answer Yes.
As the insurance company to the stock investor I could buy insurance from another insurance company protecting me, the Put Option seller. Here are the numbers and the risk.
Purchase a Put $1.20 X 1 contract = $120. $129 Strike price. 22 days until expiration.
My risk is $100 ($130 strike price sold X 100 shares less the $129 strike price purchased ) My reward, $26 if the stock is above $130 in 22 days ($146 received less the $120 paid for my insurance). I am risking $100 for a $26 gain which is 26%. This is my return for one month. I will try to do this again next month and every month into the future. If I can do it every month for 12 months my annualized profit is 312%.
One more thought before I end this lesson. You could argue that a stock could move in five possible directions. Zoom Up Rise Somewhat Flat-line Fall Somewhat Zoom Down When we act as the insurance company in the above example we can make profit in four out of the five possible directional moves in the stock. We only lose when the stock Zooms Down. Other investments require you to be spot on in your direction or timing. Don’t go away. It gets even better. Lew
Over forty years of trading. Option terminology is too difficult to understand for a newbie. I used insurance terms for this blog to make it easily understandable. No greek terminology here. Help me make this more understandable. Please carefully respond with your questions.