Options are complex financial instruments
An option is the right but not the obligation to buy or sell a product or financial instrument at an agreed price on or before a certain time in the future. Options can be written on a wide variety of financial instruments including interest rates, exchange rates and shares and on commodities such as copper or wheat.
Call and put
At the most basic level there are two types of options - call and put options. A buyer of a "call" option hopes the price of the product will rise above a certain level (known as the strike price) by the time noted on the contract. If this happens, the owner of the call option can buy the product at the strike price and immediately sell it at the market price for a profit.
The buyer of a "put" option hopes prices will fall below the strike price as they can buy the product at the market price and sell it back to the seller of the option at a higher price, once again making a profit. Buyers of options must pay a fee (the premium) to enter the contract and many options are traded on financial exchanges in the same way as shares.
More details of options and how they can be used can be found at The Options Industry Council website.
Options are used in financial markets for many reasons
Options may be bought and sold in financial markets simply in an attempt to make money by trading but they also are often used by banks, insurance companies and investment groups to structure products that may be useful for companies and individual investors. Because they provide insurance against large movements in the prices sometimes over several years, options can play an important part in the design of products that shield investors against volatility in financial markets. Companies that produce certain products, such as gold or copper, may also buy or sell options to stabilise their future income.
Options are not appropriate for most investors
Options are complex and the price at which they can be bought and sold can change quickly. An investor can make large profits but the losses can be equally large.
Options should only be considered by experienced investors who have the financial resources to withstand large losses and are willing to take the required risks. They are not an appropriate investment choice for the vast majority of retail investors.