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Suppose individual A want to make an investment in a non-liquid investment vehicle, but they would like to limit their downside if the venture turns out poorly.

Suppose another individual B would like to partake in the upside of the investment, but does not want to commit funds into a non-liquid investment for a long time.

Is it possible to set up a legally enforceable contract between the individuals so that A offers a percentage of the upside to B in exchange for B compensating A in the event of a loss?

Please redirect if this question should be posted on law.stackexchange instead. I am unsure about which place is more appropriate, so I posted here arbitrarily.

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    You just invented options...
    – littleadv
    Dec 31, 2023 at 4:44
  • @littleadv Please educate me if I'm mistaken, but my current understanding is that options always need to be mediated by a third party such as a broker-dealer, and are not truly between individuals. My question is focused on whether private individuals can sign such contracts, without any "company"-like entity in the middle.
    – merlin2011
    Dec 31, 2023 at 5:21
  • Another difference is that in this scenario, no money is exchanged between A and B until the investment is liquidated one way or the other, while I understand people pay for options up front.
    – merlin2011
    Dec 31, 2023 at 5:23
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    Brokers just... broker. The contract is between the seller and the buyer. You can sell options privately if you can find sellers yourself. Whether or not the counter party charges premium upfront is up to them, really.
    – littleadv
    Dec 31, 2023 at 7:15

1 Answer 1

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You can create a contract in the US for just about anything, so long as all parties agree to the terms of their own free will. They don't have to go through a third party. Exchange traded options use exchanges and clearing houses to facilitate negotiation, settlement and eliminate counterparty risk. You can write up a contract to buy/sell an option from someone else, set the pricing, deal with settlement, etc.

The scenario you describe is a "structured product" that can vary significantly in the terms and conditions that are used. A simple example is a "capital protected" product, where one gets, say, 80% of the gains of the S&P 500 in exchange for no losses. The counterparty gets to keep the other 20% and has to eat any losses. The time period for which gains and losses are measured can vary too, whether it's daily, weekly, monthly, yearly, etc. The percentage is what is negotiated so that both sides agree on a "fair" exchange.

The specifics of that contract would be better answered by an attorney that specializes in such agreements, but essentially the contract would outline the terms of the deal, what happens in various circumstances (death, bankruptcy, fraud, etc.) that would be legally enforceable in court.

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