My Insurance Insider and Finance Blog

Image via WikipediaWe need two things in our everyday lives that are normally considered a necessity. Shelter and mobility. And perhaps most of us owns a car, and many have purchased a home.

In addition to requiring money, these purchases follow another trait. Both require that you need to protect these assets with insurance. In fact, coverage is required by law or lender to offset any damaging and catastrophic events that might jeopardize repayment.

By the same token, there are individuals who choose to insure their stock holdings against catastrophic drops in share price or outright market collapse.

Eventually, these investors are actually “hedging” or offsetting their potential stock gains. For this, they pay a cash premium to buy insurance and guard against potential stock losses. Just as we guard against damage to our cars and houses.

But here there is one logical difference. Your house and your car are insured by companies that specialize in providing this service. And these companies are usually big business firms. Warren Buffett owns one of the largest of these insurance companies. So, why had he chosen to buy and own an insurance company?

For fulfilling a specific purpose. All insurance payments being paid to his firm to cover all those houses and autos, bring in cold hard cash every month. And that continuing cash stream allows Mr. Buffett to reinvest, leverage, and compound that cash into bigger and bigger profits.

If done wisely, prudently, and selectively as he has…you too could be on your way to returns you never thought possible using only conventional investing strategies.

And the great thing is, unlike those corporate auto and home insurance providers, but just like the great Mr. Buffett, stock insurance can be written by individual investors. You don’t have to be a company to do so. All you need to is get approved by a reputable discount brokerage, which is not so difficult.

Here’s what happens when you write “insurance” for a stock to immediately get cash deposited into your account:

First of all identify a stock as that’s the very essential activity on your part. Next, you simply write or “sell to open” a “put” contract on the associated stock’s option. Next thing you know, a premium - also known as cold hard cash -will immediately be deposited into your brokerage account.

Now just remember this-one put option contract represents 100 shares of a company stock.

For example, a certain Stock-X is currently selling for $21.00 a share. Now at this moment, cautious investors are willing to pay $1.00 in insurance “premium” for every $20 put option contract.

They do this to insure themselves against losses should the stock drop during a predefined time period. Well call it one month expiration period in this example. You, as a writer or seller of this “put” insurance, guarantee that you will buy those 100 shares should the stock fall below $20 anytime during this month long time frame.

If the stock closes above $20, at months end, the contract expires, and you simply keep the $100 that was deposited into your account when you sold the “put”. If the stock closes below $20, you agree to buy the 100 shares per contract.

So instead of just one contract, writing (selling to open) 10 “put” contracts would result in $1000 in premiums paid to you for your obligation to buy 1000 shares of Stock-X should they be assigned to you.

Just as you may have to buy the shares, should they fall below $20, during that month long period. Alternatively, you can also close your position at anytime, if you choose.

For example, the stock price may be at $20.50 halfway through the month. You can “buy to close” the position and keep some portion of the $100 deposited premium as cash profit.

Conversely, the stock price might be below $20; say its $19. In that case, the shares may be “put” to you, making you a proud new owner of 100 Stock-X shares.

Because you knew about the company and liked its prospects, and you had the cash to cover the purchase of the shares, you don’t mind owning the stock. On top of that, because you were paid $1.00 in premium per contract, your effective purchase price (before commissions) is $19.00, instead of $20.00.

At this point, since you own the shares, you might write “covered calls”, obligating you to sell your shares at a certain price, again being paid a cash premium. But, that’s another approach and another article.

So now you have the basic idea of how to write insurance for stocks which allows you to get immediate cash deposited into your account. Plus, you can buy stocks for less than you might have otherwise. Warren Buffett does this. Perhaps you should, too.