Insurance is a means of protecting against the risk of financial loss.
When it comes to financial markets, products exist to reduce risk or capitalize on opinions at low cost. One such product is an option, a derivative that acts like an insurance contract.
Options are the right to buy or sell an asset at a later date and agreed upon price.
Option buyers purchase put and call options to increase return or insure against loss.
If the option buyer was short stock, he or she would buy a call to hedge upside exposure.
If the option buyer was long stock, he or she would buy a put to hedge downside exposure.
The counterparty in this transaction writes options in exchange for a premium derived from factors such as the spot and strike price, time to maturity, volatility, as well as the rate of interest.
Option buyers pay sellers to cover their losses past a certain level and time.
Nothing is free. When it comes to selling options, similar to insurance, returns are obtained through the calculation of expected probabilities and writing of overpriced contracts. A key input in pricing formulas is volatility, the magnitude of potential change.
Volatility, a derivative of fear, compels option demand.
When the demand for an option rises, volatility and option premia rise with it. Demand for an option does not necessarily mean an underlying security will move. It just means that fear has compelled a market to increase its demand for protection.
As is true for most other aspects in life, fear is blown out of proportion and hence this is what happens in the derivatives market: fear overstates the magnitude of potential change.
So, when purchasing protection, one must be correct in their assumption on direction, time, and volatility to make money on an option. When selling, one must hedge against the risks associated with direction and volatility, among other things.
An option seller must not necessarily be directional to make money. Instead, they can leverage the dynamics of time and volatility to gain statistically measurable exposure in products traded.
In light of these market dynamics, Physik Invest derives its core edge from trading ratioed, multi-leg strategies that combine short and long positions to reduce risk and increase returns. Though direction often is a factor in positions netting a positive return, holistic market structure analysis is a requisite for entry.
About Physik Invest
Physik Invest is an actively managed, derivative-focused investment entity whose edge lies in ratioed, multi-leg strategies.
At this time, Physik Invest does not manage outside capital and is not licensed. In no way should any materials herein be construed as advice. Derivatives carry substantial risk of loss. All content is for informational purposes only.