A contractual arrangement grants the holder the right, but not the obligation, to sell a specified asset at a predetermined price (the strike price) on or before a specified date (the expiration date). This agreement involves a seller (writer) who is obligated to buy the asset if the holder exercises the option. For instance, an investor might purchase this type of contract on a stock they own as a form of insurance against a potential price decline. If the stock price falls below the strike price, the investor can exercise the option, selling the stock at the higher strike price and mitigating their losses.
These contracts provide a flexible tool for managing risk and speculating on market movements. They are often employed by investors to hedge existing positions, potentially limiting downside exposure. The value of such an arrangement is derived from the underlying asset’s price, the strike price, the time remaining until expiration, and market volatility. Historically, these agreements have been used in various markets, including equities, commodities, and currencies, to facilitate price discovery and transfer risk.
