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In my economics classes we have studied some really rudimentary concepts about insurance. I'm not really sure what qualifies as insurance to be honest.
I was wondering if options are considered a form of insurance? Is that the right way to think about options?
Perhaps a better way of phrasing the question is, "Is the primary purpose of options to provide insurance against changes in the stock's underlying value?"
No, the primary purpose of options is not to provide insurance against changes in the price of the underlying instrument: options don't have a primary purpose, they don't have an agenda, and they don't have a plan. They're just another tradeable instrument.
Some people buy them as means of insuring a position. Some people write them as a means of insuring a position.
And as Aurigae notes, in a crisis all correlations tend to one; so even if, in theory, your options insure the rest of your position, in reality, in a crisis, the counterparty risk can become very high, so the insurance is least available when it's most needed.
It could be an insurance if the price of the option trade is less than the cost of shifting the position you aim to insure if you take "Time Value" & "Intrinsic Value" into account.
If you simply want to hedge an open position because the premium for closing it is higher than the cost of the hedge, we also have to look on leveraged CFDs - the advantage would be more precise tracking of the underlying value as options may or may not track the underlying value accurately in shorter timeframes, for example earnings releases.
My take is options can only be an insurance to an open position if the above mentioned obstacles are taken into account.
Additionally to note is that derivatives (options and CFD's) also bear an issuer risk. Take a 2007 event for example, if the issuer goes bankrupt your position / account equity value might be at a loss.
I was wondering if options are considered a form of insurance? Is that the right way to think about options?
Yes, an option is a form of insurance. There are differences between insurance and options, but the existence of counterparty risk is not one of them (see my comment to EnergyNumbers's answer).
Perhaps the most important difference is that options don't require the possession of (or even the intention to possess) the underlying asset, whereas in insurance the insurable risk relates to an item in possession of either the policy holder or (in the case of liability insurance) of a third-party.
When a person has a stock, buying a put option is equivalent to purchasing an insurance policy. In options, the underlying asset is a share, whereas in insurance the underlying asset is the property insured (auto, home, boat, etc). Both insurer and the writer of an option have an obligation to indemnize the buyer of the policy or option, accordingly, in the event that the underlying asset losses value.
One difference is that the nature and implementation of options obviate processes that typically take place in an insurance context. For instance, the insurer scrutinizes whether the insured incurred moral hazard (which would lead to rejecting the insured's claim), committed fraud (which would void the policy), and what the circumstances of the loss were (for purposes of subrogation and recovery from third parties). By contrast, with options it suffices to ascertain the price of the underlying asset, the strike price, and the possession of that option, these tasks being automated at the clearinghouse on the expiration date.
Strategies such as butterfly spread combine both purchase and sale (by the same party) of options. In that type of strategies, the party is acting both as insured (in reference to the options he bought) and as insurer (in reference to the options he sold).
Options can be used in three major ways:
Note that there is some overlap in these three categories. For example, spreads would qualify as income oriented and hedging.
To keep it simple, I'm going to consider the hedging of a long equity position.
Regarding use as insurance, one could buy a long put (generally at or out-of-the-money) to protect long stock. The cost of the insurance is the premium and the deductible is the distance from the stock's current price down to the strike price. This is analogous to an insurance policy on your car, house, etc.
However, options are not that simple. If you're willing to cap the upside, a low/no cost long stock collar can be employed (sell OTM call to fund the cost of the put). Now, you only face the deductible.
Due to the nature of options, in some circumstances, their payoff can increase. For example, the underlying drops and implied volatility increases, further increasing the value of the a put.
In addition, because of the ability to roll options, you can capitalize on their price appreciation, booking option gains while maintaining 'insurance' protection.
Overall, I would say that it is not true that "the primary purpose of options to provide insurance against changes in the stock's underlying value." For the large part, they have become tools of speculators, betting on short term moves.
I see that this question was posted on Mar 23 2016, but it was already answered at Money SE by that time.
Do you need to buy car insurance? If you do, you are buying to open a put option.
First off, many investors buy options to hedge against a current position in a stock (already own the stock). But you can also try to make money off of options rather than protecting yourself.
Future readers may desire How does buying a call option make more money than simply buying stock? and What fundamental value do Options give the economy?
