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You can look at this in a different way. You can look at this like an insurance company. Insurance companies will take a look at your house, and if your house is – let’s say your house is worth $200,000. The insurance company will say, “Okay, to insure your house, if it burns down, we’ll pay for it, or whatever. The premium you will have to pay on an annual basis is $450.”
You say, “That’s not a bad deal, actually. I pay $450. If my house burns down, they pay me $200,000 for the house. That’s not a bad deal.”
Well, guess who makes more money? The insurance company, or you? The insurance company, obviously. The insurance company makes money because they write policies. It’s just like writing an option. They know that the probabilities are in their favor when they write that contract with you. They collect the $450 premium to insure your house.
They do it over hundreds of thousands of properties. They know exactly what the probabilities are, that one of those houses is going to burn down. The fact is that it’s extremely low. The probability that your house is going to burn down is extremely low.
If we go back to this trade tab for a second, you can see that the analogy. It’s just like this. Let’s say you buy the $60 strike price for 8 cents. The probability that it’s ever going to be worth any money by the 3rd week of May, when this option expires, is only 3%.
When insurance company insures your property, what do they do before they insure it? Usually, they send someone out to take a look at it. They’ll come on the property and they’ll walk around. Very few of them even go into the property. They just drive by, maybe take a picture. That’s it. If the property looks like it’s fairly well kept, they are going to insure your property.
They know. They’re going to collect that $450 premium, and they know that the probabilities of your house burning down, because you’ve been able to keep it up, is extremely low. They’re going keep that $450 premium. You don’t get that back.
They keep $450 premiums on hundreds of thousands of companies. That’s how they make their money. They just collect the premiums.
That’s what we’re doing in the market. We’re selling these contracts that have extremely low probabilities of ever being worth anything. As these options continue to erode over time, to the point where they are worth almost nothing by expiration, we get to keep the premiums, just like the insurance companies keep the premiums on the houses that they’re under-writing.
Just like an insurance company, though, every once in a while, guess what happens? A house will burn down. Because they’ve collected premiums on so many different properties, they’re able to easily pay for that one property that does burn down. Out of ten thousand properties, maybe one burns down. Well, they’ve collected $4.5 million in premiums, and they only had to pay out $200,000 once, for a house that burned down.
Who’s making money? The insurance company is. The insurance company is making a lot of money. That’s exactly how you can take a look at this business. We’re going to be selling these options, collecting the premium, just like an insurance company collects the premium, and then we’re going to protect that investment and that premium, by writing that contract, and buying another option.
We cannot write thousands and thousands of these contracts, thereby ensuring – just like an insurance company does. We do have to hedge our… It’s basically the same thing that an insurance company does. They will actually go out and purchase other contracts, and hedge their investments through their own investments, and hedge their insurance fund, and their insurance premium collections, through other investments.
This means that if an entire section of a city gets burned down, for some extremely low-probability event, they still have the money that they need in order to pay the homeowners. There are extremely low-probability events that do occasionally happen. That’s why we take both sides of the trade. We don’t sell just the call options. We sell the calls and the puts.
The reason that we do that is – well, think about this, just for a second. An insurance company, they’re only taking the premium on one side of the trade. They’re going to say, “Okay, if your house burns down…” It’s just like writing a put option. If the price of the stock goes down, we’ll pay, if your house burns down. If you’re the writer of a put option, and the price goes down, you’re going to have to pay up on it.
Unlike an insurance company, we can take both sides of the trade. We can sell the calls, and we can sell the puts. And guess what? The price can’t be in both places at one time, can it? It can only be in one price.
The price of the stock actually goes up dramatically, and this side of our position gets hurt, then we’ve got a profit. If the stock is going up, that means our profit position this side is very, very good. We made a profit on this side, even if we lost a little money on this side.
If you take a look at the adjustments CD, you’ll see exactly how we can even salvage the more profitable position on the upside, and still make a profit on the downside, too. It’s really an amazing process.