An option is a contract between two parties, which gives
the party which owns the option the right, but not the obligation, to buy or sell
something, from or to, the party which sold the option, in the
future.
Whatever can be bought or sold using an option is
called the underlying instrument. Also every option has a price, called the strike
price, at which the underlying instrument can be bought or
sold.
To understand this lets take an example. You have
bought an option to buy stock of company A, (which is also called a call
option) from another person which is valid for the next three months and
which has a strike price of $2. This means that if you express the desire, the other
person has to sell stock A to you at $2. You would use this option if the prevailing
market price of stock A is more than $2. That way you can later sell it and make gains.
If the stock price does not exceed $2, there is no point in using the option. The agreed
upon price, the call price (100 shares at $2), is termed the
href="http://www.optionseducation.org/basics/whatis/default.jsp">premium.
Options
are one of the many instruments called derivatives which help people manage risk better
and also try to make profits based on the change in price of different
assets.
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