An option is a contract that gives the buyer the right, not the obligation, to buy or sell an asset at a certain price in the future.
Why It's Important
Options play an important part in some portfolios as a way to hedge (arbitrage) against loss. Although you can purchase options on bonds, stocks, and futures, stocks are typically the go-to. So, how does it work? Let's use a simplified example.
Let's say I think Apple is going to go up. I pay a fee (or premium) to purchase a call (buy) option for the current price. This means as Apple climbs in value I can exercise my call option to get the stock for a lower price. But, let's say the stock goes down, I can opt to not exercise my option and just let it expire. If that's the case, I only lose the premium that I paid for it.
On the other side of the table, if I were the person selling the contract, I would lose money as the price went up and gain money if the buyer decided not to exercise it. Beware! If you are the person selling the contracts, you have to make sure you have enough shares to cover the order in case it gets exercised otherwise it could spell trouble.
Options are pretty risky and I don't recommend trading them unless you have a full understanding of what's going on. This topic will be discussed at my Investing: DIY - Advanced Topics event this weekend.