Probably the greatest discovery ever (3)

In my previous post probably greatest discovery ever-2 I lightly touched on the role of probability plays in option strike picking. I also compared the three alternatives on the access to the probability of option strike. In this post I am going to explore why probability is so important in option trading from another perspective. 

Option trading can be fun and could be profitable as long as one knows what option is all about. Option is a derivative of an underlying asset like stock or index. As explained in the previous post, some traders use option trading simply as a speculative tool especially those standalone Long traders who solely wish their trades can go into ITM to enjoy the exponential growth of the premium while the Short traders are usually less aggressive and just hope their trades can remain OTM so that they can earn some humble profit, ie., the already known premium amount received as soon as the trade is established. 

However, apart from the speculative application, option actually has a more functional purpose or usage. For some big investors with a huge portfolio or the fund managers who have an enormous holding under their management, the constant market fluctuation is a headache to trying to maintain the value of their holding in a comparative stable level. This is when hedging comes into play and option is a good hedging tool particularly the Long Put option against the anticipated market plummet. The profit from the Long Put position hopefully can off-set part of, if not all, the loss on the portfolio in case of a market crash. 

Unlike the speculators who hold their Long position solely for a speculative profit, the hedging Long Put is a kind of protection against an anticipated or unexpected market plummet. Just like any trade on earth that there must be counterparts for either the buyer or seller, whenever there is a Long then there is inevitably a Short in the option trading. That is to say, when one, due to the need on hedging, longs put say a stock option then s/he needs a short put counterpart so that the trade can be made. Naturally in the real world there are market makers so the counterparts might not be the same like those in the property transaction that a house owner matches with a house hunter. Anyway as a whole in the market, all the Longs must be equal to all the Shorts.

While there are at least two different types of long put traders, ie., speculators and hedge-seekers, but their counterpart, ie., the short put traders are rather unanimous. They all want to receive the profit, ie., premium, by shorting put. Short traders receive the profit upfront when the trade is made but at the same time they assume the risk of their position going into ITM if the underlying asset plummets prior to the expiry of the option and they will face potential huge loss if the ITM is very deep. As option trading is a zero sum game so the loss of the short traders is exactly the profit of the long traders and this is what and when a speculative long trader makes profit and a hedge-seeker can be protected. 

To the hedging Long trader's eye, the Short trader is just like his/her insurer whom will pay him/her back his/her loss on the fall of value on his/her portfolio. While from the fact that Short Put traders receive premium and assume the risk if there is a plummet and their loss could compensate the Long Put traders then they are really acting like an insurance company, an individual though. 

Everybody know that the business of the insurance industry is fundamentally a business based on probability. The probability of the event that being underwritten dictates the details of the policy especially the premium payable. With the perspective of the nature that Short traders are insurer underwriting the risk of their Long traders counterpart, this explains how important it is to look at the probability of the strikes of their position if they want to play safe. After all, Short traders are no different from running an insurance company. Shouldn't probability be treated as the most fundamental determinant when committing on any option trading, when the potential loss could be huge?