By John Persinos, Cabot Editorial Director

Before you read any further, make a cup of coffee. For the uninitiated, options trading can get complicated.

An option is a contract that gives its owner the right (but not the obligation) to purchase or sell an underlying asset at a specific price, on or before a certain date.

Here's a trick to understanding an option: it's just another security, just like a stock or bond. An option has a price and trades on an exchange, just like a stock or bond.

That said, an option is a contract tied to an underlying asset (like a stock or stock market index). Hence, they're categorized as "derivatives," because options derive their value from something else.

Options come in two flavors: calls and puts.

The strike price (sometimes called the "exercise price") is specified as part of the option contract. The strike price is the price at which an underlying asset can be purchased or sold. For calls, this is the price an asset must rise above to make money; for calls, it's the price it must fall below. These events must occur prior to the expiration date.

If you think the price of a certain asset will increase substantially before the option expires, you'd purchase a call option. If you think a stock will dramatically drop in value, you'd purchase a put. Accordingly, there are four types of players in options markets: buyers of calls; seller of calls; buyers of puts; sellers of puts.

Options take advantage of leverage because they allow you to control a large number of shares with relatively little money—a great example of Archimedes’ lever.

Assume you buy one call option. The option controls 100 shares of a stock. The option has a strike price of $9 per share. If the current market price is $10, the total market value of the stock is $1,000 ($10 x 100 = $1,000), but with your option, you have the right to buy the stock for $900 ($9 x 100 = $900). The value of your option is $100.

If the market price rises to $11 per share, the market value of the stock rises to $1,100. Because your exercise price remains the same ($900), the value of your option is now $200, a 100% jump produced by only a 10% increase in the price of the underlying stock.

The overriding point is this: There's significant leverage in owning options. A small or modest bet can pay off with a huge win—if you're right. If you're not right, your option will can lose as much as 100% of your investment.

Aside from their complexity, there's another caveat about options: time is not your friend. If your option expires in three months, you not only need to be right about your hunch, but you need to be right very soon. Within such a short window, conditions can change considerably, putting you at the mercy of the market's vicissitudes.