An option is a contract that sets a price and time for the sale or purchase of a financial asset. It derives its value from the performance of an underlying security. Suppose Peggy believes XYZ Corporation’s shares are undervalued at $50. She buys a call option from Mike. They agree on a strike price of $55, giving Peggy the right to buy XYZ shares at $55 by the exercise date that’s three months away. If XYZ rises to, say, $60 prior to the exercise date, Peggy will exercise her option and buy the shares from Mike at $55. Then Peggy can sell her shares in the market at $60. If XYZ had remained below $55, Peggy would not have exercised her option. Mike would keep the premium -- what Peggy paid to buy the call option. If Peggy purchases a put option, she acquires the right to sell the security at a later date at a strike price. Suppose she and Mike agree on a strike price of $45. If the price falls, say to $40, Peggy can buy XYZ shares in the market at $40, and sell them to Mike at $45. If XYZ remained above $45, Peggy would not have exercised her option. If Peggy owns shares of XYZ and expects them to decline, she can hedge by buying a put on XYZ and locking in a minimum sale price.