An option is a financial instrument that conveys the right, but not the obligation, to buy or sell a security, futures contract or other financial entity.
An option provides an explicit structure for the potential transaction, detailing the exact type and quantity of financial instrument to be bought or sold, the price for the transaction, and the length of time that the transaction right will be granted.
As a hypothetical example, a stock option could be an option to purchase (a "call" option) or sell (a "put" option) 100 shares of XYZ Corporation at $50 per share, with an expiration date of June 30, 2007.
An option has its own value that is determined by a number of factors, including the amount of time left to expiration, the current value of the security it represents, and the amount of volatility in the security's market. The option buyer pays the cost of the option (the "premium"), which is transferred to the seller minus the seller's transaction costs.
Until the end of the expiration day, the buyer of this option would have the right to exercise his option and either buy or sell the stock (depending on whether he bought a put or call option). In the above example, no matter at what price XYZ stock is trading, exercising a call option (an option to purchase) will result in the option owner buying 100 shares of XYZ at $50 per share. Once exercised, the option is removed from the owner's portfolio.
If the buyer of the option exercises it, the seller is given the opposing side of the exercise transaction. In the above simple example, if the option buyer exercises his call option and purchases 100 shares of XYZ at $50, the option seller will be made to sell 100 shares of XYZ at $50.
If the owner of the option does not exercise it, then at the end of the expiration day, the option is removed from the owner's portfolio and no action is taken. The seller of that option will no longer have the risk of being assigned the opposite side of that option's transaction.
Options may be bought and sold purely for the profit and loss of those transactions, where the buyers and sellers have no intention of exercising the options and entering into transactions in the underlying instrument. Options may also be bought and sold in specific combinations, either with each other or with the underlying security, to create different risk and reward profiles.