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Options for dummies. Can you explain how puts & calls work, simply?
Great answer by @duffbeer. Only thing to add is that the option itself becomes a tradeable asset. Here's my go at filling out the answer from @duffbeer. "Hey kid... So you have this brand-new video game Manic Mazes that you paid $50 for on Jan 1st that you want to sell two months from now" "Yes, Mr. Video Game Broker, but I want to lock in a price so I know how much to save for a new Tickle Me Elmo for my baby sister." "Ok, for $3, I'll sell you a 'Put' option so you can sell the game to me for $40 in two months." Kid says "Ok!", sends $3 to Mr Game Broker who sends our kid a piece of paper saying: The holder of this piece of paper can sell the game Manic Mazes to Mr Game Broker for $40 on March 1st. .... One month later .... News comes out that Manic Mazes is full of bugs, and the price in the shops is heavily discounted to $30. Mr Options Trader realizes that our kid holds a contract written by Mr Game Broker which effectively allows our kid to sell the game at $10 over the price of the new game, so maybe about $15 over the price in the second-hand market (which he reckons might be about $25 on March 1st). He calls up our kid. "Hey kid, you know that Put option that Mr Game Broker sold to you you a month ago, wanna sell it to me for $13?" (He wants to get it a couple of bucks cheaper than his $15 fair valuation.) Kid thinks:  hmmm ... that would be a $10 net profit for me on that Put Option, but I wouldn't be able to sell the game for $40 next month, I'd likely only get something like $25 for it. So I would kind-of be getting $10 now rather than potentially getting $12 in a month. Note: The $12 is because there could be $15 from exercising the put option (selling for $40 a game worth only $25 in the second-hand market) minus the original cost of $3 for the Put option. Kid likes the idea and replies: "Done!". Next day kid sends the Put option contract to Mr Options Trader and receives $13 in return. Our kid bought the Put option and later sold it for a profit, and all of this happened before the option reached its expiry date.