EC It's An Option Buyer's Market

The fact that options can be used in this manner – as surrogates for shares of stock – tends to alter their appearance to those looking at the options market from the outside. To an untrained observer, it can be difficult to discern those in the options market who are using options as surrogates for stock from those who are using options as insurance.

Thankfully, it is easy to separate those buying options as insurance from those buying options for other purposes:

  • Out-of-the-money (OTM) strike prices tend to be used for speculation because they have very low premiums but very high deductibles
  • At-the-money (ATM) strike prices tend to be used as insurance policies because they have moderate premiums and no deductibles
  • In-the-money (ITM) strike prices tend to be used as stock surrogates because they have very high premiums but actually have negative deductibles (exercising the option provides a better price than trading the stock on the open market, in some cases the net premium or 'time premium' is nearly zero when considering the intrinsic value of the negative deductible) For example, if a stock is trading at $100 per share, a Call option with a strike price of $90 would have zero time premium if that Call option was trading at $10. Essentially the Call buyer is entitled to all the profits on the stock if it trades above $100 per share, plus $10 per share. The deductible in that case is actually negative: -$10, so the entire $10 premium would be recouped at stock prices above $100.

In general, the only options a trader will buy if those options are being used purely as insurance for stock positions, to protect gains for example, are those with strike prices very near the current stock price – ATM options. OTM and ITM options may be used for other purposes, but generally not for stock insurance because the deductible is far too high or far too low, respectively, for such options to be considered analogous to most other traditional insurance policies.

Traders may buy options at OTM strikes to limit risk on a stock or option position, and technically these options could be considered a form of insurance, but the fact that these options have a high deductible means the trader is accepting a good deal of risk. Essentially, any trader buying OTM options is speculating.

A trader who buys OTM options outright is speculating that the stock price will move significantly toward the strike price or beyond, while a trader who buys OTM options as a hedge against an existing stock or option is speculating that the stock price will not move significantly toward the strike price. For example, any trader who buys OTM Puts as protection for shares of stock that are owned is speculating that the stock price will move higher, since this trader would suffer significant losses (the deductible) before the stock reached the strike price.

A trader who buys an insurance policy with zero deductible (or a negative deductible) isn't truly buying insurance in the traditional sense either. Zero deductible policies are more analogous to a prepaid maintenance agreement than they are to traditional insurance. So too do ITM stock options more resemble prepaid stock positions than insurance policies. That's why ITM options lend themselves to being used (or abused) as stock surrogates.

Analyzing Options as Insurance

OTM options are used for speculation, ITM options are used as surrogates; only ATM options are used as insurance. Thus, it makes sense to analyze only ATM options when studying the options-trading environment from the perspective of it being a stock insurance industry.

When someone buys a house and insures it, they generally don’t expect to profit if the house burns down. They expect to be protected. When someone buys a car and insures it, they don’t expect to profit from running the car into a ditch. In either case, the insured will benefit from the insurance, but will still suffer some level of loss (the deductible).

If arsonists and bad drivers suddenly started profiting, it would be time to pay attention. In some ways, that is just what is happening right now for the S&P 500. Options that are normally used for insurance are returning profits for the option owners.

Options with at-the-money (ATM) strike prices are not just profitable for buyers these days, but uncommonly profitable. Buying options has suddenly become the profitable thing to do, not just for speculators and those using options as stock surrogates, but at strike prices that normally function only as insurance policies.

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Obviously, no insurance industry is sustainable over the long term if those buying insurance are able to earn profits. That includes the options market. S&P 500 options used as insurance – ATM strike prices – cannot return profits for buyers indefinitely. The only reason profits are possible on any type of insurance is due to the fact that over the long term the seller of the insurance collects at least enough premiums to pay all the claims. Without sufficient premiums in the long term, the insurance industry collapses.

The options insurance industry is no different. It will not collapse in the long term because periods of profitability for buyers will always be offset by periods of profit for sellers. The current phase of profitability for buyers of ATM options on the S&P 500 is therefore an outlier – an anomaly.

Insurance-Buyer's Profit Indicates Irrational Market

While profits for buyers of ATM options on the S&P 500 are not uncommon, they don’t last forever, and generally disappear within a few weeks to a few months. It is therefore important for traders to know when these profits are occurring, and when they are not. Currently they are.

When insurance becomes profitable for policy owners it is time to pay attention. It represents a shift. For, if fire insurance became attractive to arsonists or car insurance became attractive to reckless divers, as a way to earn income, it would suggest that arsonists and reckless drivers were in control, at least temporarily.

So too are stock buyers and greed in control of an overbought stock market when stock insurance becomes attractive. It won’t last forever. It can’t. But an overbought stock can stay overbought for a long time, even if it is unsustainable in the long run. Who wouldn’t be tempted to join an unsustainable cause if it was profitable?

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