An option is a mechanism for guaranteeing a future price when buying or selling stocks and shares. The option, if exercised, will guarantee a fixed price on buying or a fixed price on selling the stocks at a future date, depending on the type of option purchased. What an investor is buying is the option to buy or sell stocks at a set cost at the date agreed. The investor can decide whether or not to exercise their option at the appropriate time, there is no obligation on the investor to buy or sell stocks as a result of purchasing the option.
The reason investors buy options is to hedge their bets on movements on the stock market. If you purchase an option to buy stock at a specified price, if the stock price increases above the option price then it is likely that the option holder will buy at the lower option price. The investor can then make a quick profit by selling at the current market price. The opposite logic applies when an option to sell is purchased. In effect, this is a form of gambling on the movement of stock prices.
How options work is probably best explained by use of an example. An investor may decide to buy an option to purchase a 100 share of a stock at a price of $50 in six months time (this is called a call option). The investor will pay a fee to buy that call option. If we assume the current price to buy that stock is $45, it would appear that the investor is offering to pay more than the stock is worth, and this is true. The reason an investor might do this is because he believes the stock price will rise over the next six months, but rather than risk his capital (ie to hedge against the risk that the stock does not increase in price, or worse decreases in value), he will only risk the fee he has paid to buy the option.
If in six months time the market value of the stock is less than $50, then the investor has no incentive to exercise his option. If, however, the stock price has increased to say $60, the investor is likely to buy the stock at the agreed price ($50) and may sell immediately at the market value of $60, thus making a 20% profit.
The opposite of a call option (an option to buy at a fixed price in the future) is called a put option. A put option confers the right to sell stock at a specified price at a future date. An investor may decide to buy an option to sell a 100 share of a stock at a price of $50 in six months time. The investor will pay a premium for that put option. If we assume that the current value of the stock is $55, it would appear that he is willing to sell the stock for less than it is worth, and this is true. The reason an investor might do this is because he believes the value of the stock will fall over the next six months. In doing this, the investor is insuring against the risk of losing money if the stock price falls while still being able to profit if that does not happen.
If in six months time the market value of the stock is more than $50, then the investor has no incentive to exercise his option. If, however, the stock price has fallen to say $40, the investor is likely to sell the stock at the agreed price ($50) and has thus limited his loss.
In either case, investing in a call option or investing in a put option, a fee is paid to purchase the option. If, as a result of stock value movements, the investor decides not to exercise their rights under the option, the fee cannot be reclaimed. However, the fee is a known amount and limits the exposure of the investor to losing money. It should be noted that the longer the option runs and the greater the difference in the option price as compared to the current market price when the option is purchased, the greater the fee to purchase the option will be.