Option Credit Spreads

Writing option is like insurance business. Many small to medium-size firms run their own health insurance plan. So for normal reimbursement, they just pay from the pool. However for extreme risk, say above $2M per employer, the company buys coverage, ie reinsurance, from a third party with really really deep pocket. Overall, it is still much cheaper than contracting everything out to the third party insurance company.

In option world, you can achieve the same by selling a credit spread, instead of writing a naked option. Sell the near-strike options (sell the body), and buy far-out options (buy the wing). 

In writing option spreads, most of time you make money. Say 90% of time, you make $10. Once in a while you lose. Say 10% of time, you lose $50 (without wing protection you loss can be unlimited in options). So it is still a high margin business, but you need to make sure you do not become too aggressive and write too many options. If you manage risk correctly and do not blow up, then you can keep writing new options, ie you can stay in the insurance policies. Time is on your side.

The reinsurance business or deeply OTM options is just more extreme insurance policy. If you buy them, most of the time you lose money without using the coverage. Say 99% time, you lose $100 since your premium paid expires worthless. 1% time you gain $10000. The reinsurance policy seller / underwriter typically has even higher profit margin in an acturial sense. However it needs really deep pocket and pristine credit to operate. 

Reinsurance is WB's favorite business model. If you are WB, you can also sell 10-20 year LEAPs WITHOUT collateral. We as retail trader cannot do that. For most of us, we should be happy to write "normal" insurance policy, ie selling credit spreads in options, not selling naked options.

Just my 2c.