Decidedly not for the faint of heart -- or the easily confused -- options trading is an aggressive investment strategy with huge risks and the potential for fast, enormous returns. Simply put, an option is a contract that gives a buyer the right to purchase or sell a specific asset, such as a particular stock or a piece of real estate, at a certain price before a specified expiration date [source: Investopedia.com]. The buyer is not required to purchase or sell the asset at the contracted price, but instead pays for the contract itself, or the option.
Imagine that stock in MegaCorp is currently trading at $10 per share. If an investor believes that MegaCorp's stock price is on the rise, he or she might pay a premium (the cost of the option contract itself) of $2.20 per share for the right to purchase 100 shares of MegaCorp at $12 per share within the next 60 days. At the end of the 60 days, MegaCorp stock is trading at just $8 per share, so the option is worthless, and the investor allows it to expire. The investor's loss is $220 ($2.20 per share x 100 shares).
However, if MegaCorp stock had gone up to $20 per share within the 60-day timeframe, the investor could have bought 100 shares at $14.20 per share (the $12 strike price plus the $2.20 premium per share), then immediately sold them at $20 per share, for a return of $580.
Options also give investors a way to make money if the market declines: Investors who believe that MegaCorp stock is on its way down can purchase an option giving them the right to sell the stock at a certain price instead.