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

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2. Trade Selection

Trade selection at a hedge fund is the equivalent of the underwriting function in an insurance company. If underwriting is executed correctly and the risk is priced fairly, the business is sound. The business should make money because premiums collected are adequate compensation for the risk taken. If underwriting is executed poorly and the risk being taken is not well defined, the premiums collected might not be enough to cover the risks.

A good example of this is the contrast of two big events. One event is losses from Hurricane Katrina in 2005, and the second is losses on mortgage-backed securities that led to the implosion of AIG in 2008. Both events were big hits to the insurance industry. The first event, Hurricane Katrina, ...

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