A contractual agreement enabling the holder to buy or sell a security at a
designated price for a specified period of time, unaffected by movements in its
market price during the period. Put and call options, purchased both for
speculative and hedging reasons, are made by persons anticipating changes in
stock prices. A put gives its holder an option to sell, or put, shares to the
other party at a fixed put price even though the market price declines; a call,
on the other hand, gives the holder an option to buy, or call for, shares at a
fixed call price notwithstanding a market rise.
Another form of option, a stock purchase warrant, entitles its owner to buy
shares of a common stock at a specified price (the exercise price of the
warrant). Warrants are often issued with senior securities (preferred stocks and
bonds) as "sweeteners" to increase their salability. They may also be issued
directly as part of the compensation for underwriters of new issues and other
promoters in the establishment of a new business.
The stock rights option gives a stockholder the choice of (1) buying
additional stock at a price below the current market price for a specified
period of time, usually briefer than the life span of stock purchase warrants,
or (2) selling the rights on the market. They are the customary way of
implementing the stockholder's preemptive right to subscribe to whatever
additional stock is issued in order to maintain his proportionate equity in the
corporation and its control.
American corporations frequently issue employee stock options as a form of
incentive compensation for their executives. The underlying theory is that an
option constitutes an incentive to do what will improve the company's fortunes
and thus raise the value of its stock. The employee stock option was widely used
as a means of supplementing the compensation of high-salaried employees after
1950, when federal income-tax provisions permitted the "spread" between high
market price and the lower option price to be treated, upon sale of the stock,
as capital gain, taxable at a 25 percent ceiling rather than the higher personal
income-tax rates. In 1976, however, such profit was designated as ordinary
income.
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