WHAT IS AN OPTION?
Every human being on this planet must
deal, in one way or another, with unexpected
events that disrupt their lifestyle. Unfortunately, most of us come to learn this fact after
our lives have been disrupted many times! From the guy that doesn’t own one worldly
possession to the most wealthy of
individuals, the possibility of loss always exists. The
health and life of people is the most basic asset, an asset which millions of people across
the world try to protect. Either by trying to stay healthy and out of harms way through
being fit, workin
g out and eating healthy or by having health or life insurance in the event
that something does happen. It is built into our DNA that we must constantly weigh the
risks and consequences of what we do with the possible rewards and outcomes.
industry is an empire that deals exclusively with these risks. Through
statistical inference and actuarial data tables, an insurance company essentially uses the
law of large numbers to their advantage. First of all they provide a service to the general
population and for a cost they accept the risk that humans encounter in their daily lives.
Through sampling techniques they have proven that any given event has a certain
likelihood of occurrence when certain elements are present. Whether it be the avera
number of years a man age 50 that doesn’t smoke, who has low cholesterol and blood
pressure will live, to the possibility that an eighteen year old male driving a four wheel
truck living in Colorado will wreck. Secondly, the insurance company calculate
premium that over time and through many policies generates more revenue then claims
paid. Catastrophic events and anomalies can devastate insurance companies however and
cause premiums to increase as this new data is now included in their statistical
The industry is designed not to fail over the long run based on this law of large numbers
and total premiums collected offset all payouts issued when time takes over the equation.
More and different policies can be written to increase the odds of
Insurance companies will try to cap their risk by selling policies with maximum pay
values. In other words if disaster strikes and policies get cashed against the writer, they
have limited total loss and will survive and prosper lo
term in spite of this.
Option contracts share many of the same characteristics with insurance contracts. Some
of the basics include; a premium, a stated life of the policy, and an exercise or payout
certain conditions are met. As we progress through
this course we will begin to see the
many similarities, and differences, that options share with insurance contracts.
Options developed as a means to help manage certain types of risk, not as a vehicle for
speculation. They were original
ly created by merchants that wanted to ensure there
would be a market for their goods at a specific time and price. One such merchant was
the ancient Greek philosopher Thales. As a student of astrology and general
businessman, Thales predicted a great ol
ive harvest in the spring while it was still winter.