Option

From Wikicpa

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties.

The idea behind an option is present in many everyday situations. Say, for example, that you find a painting that you'd like to purchase. Unfortunately, you won't have the cash to buy it for another two weeks. You meet with the owner and negotiate a deal that gives you an option to buy the painting in two weeks for a price of $15,000. The owner agrees, but for this option, you pay a price of $200.

If in the course of the two weeks, you discover that the painting is a rare work of a famous painter and its value is actually $150,000, the current owner is obligated to still sell it to you for $15,000. On the other hand if you discover the painting is a fake, and is worth only $500, you can walk away from the deal. But of course the owner gets to keep your $200 option fee.

This example demonstrates two very important points. First, when you buy an option, you have a right but not an obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, you lose 100% of your investment, which is the money you used to pay for the option. Second, an option is merely a contract that deals with an underlying asset. For this reason, options are called derivatives, which means an option derives its value from something else.