Options are highly versatile financial instruments that open up a wide range of investment strategies for individual investors. Options have been actively traded on the Chicago Board of Options Exchange (CBOE) since 1973. In essence, an option represents a contract between two parties to buy or sell a financial asset. The contract gives the owner the right to buy the asset (call option) or the right to sell the asset (put option) at a predetermined price and within a predetermined time frame. An option gives its owner the right to do something in the future. The owner of an option has the right but is not obligated to exercise the terms of the contract. If the owner of an option does not exercise this right before the predetermined time frame, then the option and the opportunity to exercise it cease to exist, and the option expires.
Buying a call option for a financial asset is like buying a coupon for something. For example, a coupon for a concert ticket can be thought of as a call option for admission to a concert. Since the price of a concert ticket can go up in the weeks and days before the event, a savvy concert goer might want to lock in a ticket price by spending a little money (a premium) on a coupon that lets him pay a fixed price (the strike price) for a ticket anytime before the concert. Three things can happen to the ticket price in an open market before the concert: the price can go up, it can stay the same, or it can go down. When the ticket price goes up, the coupon owner can buy at a discount because the coupon guarantees a lower price. This is a profitable situation for the coupon owner because he can buy at a discount and immediately sell in the open market at a higher price. When the ticket price stays the same, the coupon owner pays full price, loses the small cost of the coupon, but if tickets are running out before the concert, then the coupon gives him time to buy until the night of the concert. When the price of a concert ticket goes down, maybe because the concert is not that great, the coupon owner may not want to buy a ticket after all, even at a lower price. In this case, a coupon owner loses the small cost of the coupon, but by waiting things out, he doesn't end up spending full price for a ticket up front, only to be stuck with admission to a lousy concert.
Buying a put option for a financial asset is like buying insurance for something. Spending a little money on insurance provides price protection for the thing insured. The value of a ticket can be insured by paying a premium. If the concert ticket price goes up or stays the same, then the insurance is not needed and the money spent on price protection is lost. If the ticket price goes down because the concert is not that great, then this form of insurance guarantees that the ticket holder will get a fixed price for the ticket (a refund), even if the market value of a ticket is much lower. When ticket prices go down, the insurance covers the difference between a fixed, higher price and the current, much lower price, and itself becomes more valuable as people are willing to pay more for greater price protection. When prices go down, the insurance can be sold for more than its original cost. For a small premium, insurance protects the value of the concert ticket if you buy one up front, provides time to make a purchase decision at a fixed price if you want to wait and see what happens to ticket prices until the concert, and increases in value when ticket prices decline.
When you sell something, you get to keep the money collected from the sale, provided that everything goes as expected through the end of a transaction. A ticket coupon seller collects the price of a coupon and expects concert ticket prices to either stay the same or to go down by the night of the concert, in order to keep the price of the coupon as his profit, just as a call option seller typically expects the price of a stock to stay the same or to go down by expiration for the same reason: to keep the premium. The seller of insurance for a concert ticket keeps the premium collected when concert ticket prices stay the same or go up, just as a put option seller collects a premium, and keeps it as a profit when stock prices stay the same or go up.
At a fundamental level, options markets behave like the markets for concert ticket coupons and insurance in these examples: buyers take one side, sellers take the other, and both parties speculate on the price of an underlying asset.
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