The Option Trader’s Hedge Fund: A Business Framework for Trading Equity and Index Options by Dennis A. Chen

The Option Trader’s Hedge Fund: A Business Framework for Trading Equity and Index Options by Dennis A. Chen

Part I: The Framework

1. The Insurance Business
In this chapter we show you how to create a business of trading options
successfully by using the framework of an insurance company. This is the
same framework used at a hedge fund managed by Dennis (the co-author of
this book). So, for this book, we create the concept of The One Man
Insurance Company (TOMIC). You will need to know how the insurance
business works. What is the good, the bad, and the ugly of the insurance
business? How does an insurance company make money? How does it lose
money? What are the key profit drivers of the business, and what are the key
success factors?
Insurance is the equitable transfer of risk from one entity to another in
exchange for compensation, called a premium. The insurance companies
make money by taking risks from others in exchange for a premium. For
example, if you own a vehicle, you probably have car insurance that protects
your asset against a big loss like theft or accident. The insurance company
collects a premium each year to protect you against the big loss. The
insurance company pays you to make you whole. For an insurance company
to function, it must know what risks it is willing to insure. It also needs to
know how much premium it needs to charge to be able to back the risks and
still earn a profit. It will need to know the car-theft statistics and accident
statistics for your car’s model and year. Using that information, the company
is able to price coverage and charge a premium that allows the company to
make a profit on the large pool of car insurance it writes.
Figure 1.1 illustrates a generic value chain of an insurance company.

The Option Trader’s Hedge Fund: A Business Framework for Trading Equity and Index Options by Dennis A. Chen