Suppose that you are a happily married and risk-averse individual. Being risk-averse, you prudently take out a life insurance policy on your spouse. Things are going splendidly until one day OH NO your spouse accidentally gets thrown in front of a bus. And dies.
You’re pretty bummed about this, but your grief is somewhat mitigated by that multimillion-dollar life insurance policy. This is called risk-hedging.
Now, suppose that you also own a diverse basket of stocks that look like the S&P 500 index. You know that markets sometimes suffer downturns and you would hate to have your portfolio wiped out. You purchase some S&P 500 options so that, if your stock portfolio gets demolished in a market crash, you can sell the S&P 500 index at a price that is acceptable to your risk profile. This is another form of risk-hedging.
Nobody knows where the market’s gonna go. Maybe you like the perceived safety of long-dated options. If you’re Nassim Nicholas Taleb betting on black swan events, you buy long-dated options on the cheap hoping some won’t expire worthless. Or maybe you prefer to buy something closer to expiration so your cash isn’t tied up.
Think back to the life insurance policy you had on your spouse. Maybe it was a bit silly to pay monthly premiums for all those months your spouse didn’t die. Maybe you should have waited until 20 minutes before pulling the plug to purchase that life insurance policy*.
Nadex, the North American Derivatives Exchange, opened trading on 20-minute options last week. Previously, their shortest-term contract was two hours. However, Nadex had long observed that most trading activity occurs in the minutes before expiration. Instead of having trading volume surge every two hours, why not promote this same activity every 20 minutes?
Critics made some noise about how this amounts to little more than gambling. In a zero-sum game like the options market, every individual who buys an option to lower personal risk has a counterparty taking an equal and opposite risk. The market allows those who don’t want risk to purchase downside protection from those who do. By giving individuals the freedom to tailor the world to their personal risk preferences, the options market improves social welfare and ensures peace and prosperity for all.
*It might be hard to find an insurer for your spouse on life support, but surely there must be someone out there willing to bet on the off-chance that your spouse makes a miraculous recovery once disconnected from the ventilator.