stock option

A stock option is a contract that enables the holder to buy or sell a security at a designated price (called the “exercise” or “strike” price) for a specified period of time. An option’s strike price is not affected by changes in market prices, so these contracts can be useful for speculation (seeking a profit) and hedging (protecting current positions). A put option gives the owner the right, but not the obligation, to sell the underlying stock at the strike price on or before a certain date (“expiration”). A call option gives the owner the right, but not the obligation, to buy the underlying stock at the exercise price on or before the expiration date.

The listed options market consists of call and put option contracts traded on exchanges in the U.S. and abroad. Buyers and sellers of listed options may trade them for a variety of reasons, including for speculation, as a strategy for targeting entry and exit points for a stock trade, for hedging a position (or an entire portfolio), or in an effort to earn income.

A trade in the listed options market constitutes a contract between the buyer and seller, and any exchange of shares due to the exercise of an option is from shares that exist in the secondary market (i.e., held by investors and traded on stock exchanges).

A specific 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) directly from the issuing company (unlike a listed option, which involves two external counterparties). Warrants, which theoretically rise in value as share prices increase, are often issued as “sweeteners” to holders of preferred stocks and corporate bonds) as incentives to invest in these securities, which pay a stable fixed rate but don’t necessarily rise in value as the company grows.

Warrants 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.

American corporations frequently issue call options to executives and other employees as a form of incentive compensation. The underlying theory is that a call option provides an incentive for employees to do what they can to improve the company’s fortunes and thus raise the value of its stock. Using stock options as incentives requires complicated accounting and tax treatment, which can be a major drawback for some companies.

Stock options are particularly popular for start-up companies that are unable to provide their employees with high wages. If the company grows, the options can (potentially) translate into an attractive profit or a big payoff in the event of a merger or initial public offering (IPO).

The employee incentive stock option was widely used to supplement the compensation of high-salaried employees after 1950. At that time, federal income tax provisions permitted the “spread” between a high market price and a lower option price to be treated as a capital gain, which was taxable at a 25% ceiling rather than the higher personal income tax rates. In 1976, however, such profit was designated as ordinary income.

Incentive stock options differ from listed options, which are call and put options that are traded on exchanges.

Learn more about option contracts, incentive stock options, selling call and put options, and option collar trades.