Most of the time it pays to sell insurance, how do you think Warren Buffett became one of the richest men on the planet? He is known for being a shrewd investor, but the bulk of his fortune was built upon insurance companies.
When insurance is underwritten properly, it is one of the most lucrative businesses in the world. But when it is done wrong, massive amounts of money can be lost.
Just think about it.
How much do you pay for life insurance, health insurance, fire insurance, homeowner’s insurance, liability insurance, and so on? All that money you are paying has to go somewhere and that somewhere is your insurance company’s bottom line.
Usually this involves selling options like puts and calls, which are really just insurance policies on the price of a stock or a stock index.
A put for example is like an insurance policy to protect a portfolio if a stock craters. You can buy a put to protect your portfolio in the event of a market crash. But the really cool thing is that you can do the opposite and sell a put too. You can essentially become a mini insurance company and make money if the market does not crash.
Now options are perceived as extremely risky, but it isn’t the option that is inherently risky, it is how the option is used.
For example, let’s say you want to own a stock at $50 dollars per share, but it is currently selling for $55. You could buy the stock for $55, but if it falls to $50 you are going to feel foolish.
What you could do instead is sell a put option with a strike price of $50 and collect a few dollars upfront.
If the stock stays above $50, you will get to keep the premium that you collected. What’s more you can sell another put and collect even more premium.
If the stock falls below $50, the person you sold the put to will sell the stock to you for $50. But you get to keep the premium that you collected, so you are already ahead. Plus you own a stock at that price that you were willing to pay for it.
When you compare put selling to just buying the stock at $55, which was an unattractive price to you, you’ll see that you come out ahead. If the stock goes down, you get the stock at the price that you want and you get to keep the premium. If the stock stays flat or goes up, you get to keep the premium and write another policy by selling another put.
Overall, you can make more money, while taking less risk than buying the stock outright. What’s not to like about this excellent hedge fund strategy?