This is one of the most important terms in psychology, so make sure you understand it well. I'm sure you've used this term many times, but you may have been using it in a way that is different than it is used in psychology.
The first thing you must remember is that psychology is a science. As such it is based on observable events and the scientific method. But there are so many different events and facts about behavior that trying to make sense of everything is simply not realistic. So, we use theories to help organize lots of different observable events, make sense of them, make predictions about them, and connect them to some more comprehensive principles.
In essence, theories explain observable events in a meaningful way. Keep in mind that theories are not as specific as hypotheses, which are so specific that we use them to make predictions in research. Theories are more general explanations about behavior and events.
For example, if I see many people scream in pain when they touch a flame, I could theorize that extreme heat causes pain (that's a tough one, eh?).