Selling 'Insurance' on Stocks

Around 1688, a British man named Edward Lloyd opened a coffee shop near London's docks and started tracking ship arrivals and departures. His shop became the de facto center for a burgeoning insurance industry...

Brokers would offer insurance policies against lost or looted ships and use the crowd to spread the risk around. After formalizing this consortium, it evolved into Lloyd's of London and still operates today.

The point is, guaranteeing reimbursement on a burned down house (or sunken ship) sounds risky, but it makes you real money. Insurance companies are profitable.

The key is to be a good insurer. And to be a profitable insurer, you don't offer a policy to former arsonists or to those living in the homes near the kerosene factory. That would be too risky.

We perform the same diligence when we painstakingly analyze stocks and their underlying businesses to find stocks that we think won't go down.

Options are like insurance.

Actually, it's more accurate to remove one word and say...

Options are insurance.

And in my Retirement Trader newsletter, we are the insurance company.

Each option contract has two sides – a buyer and a seller. And while options can be used for all sorts of things, many put buyers purchase puts as an insurance policy.

These investors hold shares of a particular stock and want some assurance that they'll be able to sell them and limit their losses. That's an insurance policy, one that we're happy to sell.

Let's take this example further and talk about how insurance works...

Say you own a home worth $200,000. That's a valuable asset. And if it catches fire and burns down, you'll be financially devastated.

But if you buy homeowners insurance, you may pay something like $1,000 a year for it. (Homeowners insurance covers a number of events, but for the sake of this example we'll imagine that only fires destroy homes.)

When you buy insurance, you just bought a put on your home with a strike price of $200,000. You pay a certain amount in premium, and if nothing happens, you lose that money you spent on the put.

However, if your house burns down – you'll be made whole again from the insurance company at the guaranteed amount of $200,000.

That means on the other end, the insurance company is a put seller. And that's who we are in Retirement Trader... We (the insurance company) collect the premium and get to keep it.

In the case of tragedy, the insurance company will have to pony up capital to meet its end of the obligation.

The analogy of options being insurance does break down in one aspect. The insurance company just pays out $200,000 in the event of fire. In our put-seller insurance business, we pay out the agreed amount – and we end up owning those shares of a valuable company.

Lots of folks think options are too risky. But here's the trick...

The other key measure here is that insurance companies know the numbers and they'll spread the risk. If 1% of homes burn down, they know exactly how many policies they'll need to sell and how much they'll need to charge in premiums to cover an occasional payout, while still building some profit.

We do the same thing. We spread our bets around the market and only accept returns that we feel will compensate us for the risk.

We doubt few people have an interest in raising capital, getting licensed, hiring a staff, and whatever else you need to do to start an insurance company.

But running a profitable business by selling "stock insurance" with a few clicks in your brokerage account sounds pretty attractive to us.

We think this analogy can help you see how options exist all around us and maybe provide you with a deeper understanding of just what we're doing.

Of course, in the abstract, it might be difficult for anyone who has never traded options before to really understand how they can help you generate safe, steady income in your portfolio.

So I recently sat down with someone completely new to options trading to show him how just a few minutes of his time could earn him more than $3,000.

You can see exactly how it's done – and get my free recommendation – right here.

What We're Reading...

Here's to our health, wealth, and a great retirement,

Dr. David Eifrig and the Health & Wealth Bulletin Research Team
August 3, 2023