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This year I had an unexpected and pleasant surprise at work.  I was awarded stock options for 700 shares pricing in March.  The options vest 33.3% per year over the next three years.

It is exciting to be awarded options.  This ties my compensation to the company’s performance over the next three years.  From the company perspective, it is better to have employee compensation tied to company performance, as employees may work harder to ensure the company is successful.

Here is how employee stock options work, using my situation as an example:

• First, I am notified that I will receive options.  I was given the number of shares and the pricing date for the options.
• On the pricing date in March, my options are given a fixed value per share.  This is tied to the market price on that date.  The price is called a strike price.
• Every year for the next three years, a portion of those options become vested, or available for use.
• If the market value of my company stock is higher than the strike price on any date past the vesting date, I have the option to buy shares of the company stock at the strike price.  If the price is higher than the strike price, I can sell immediately for the market price and keep the profit.  If it is below the strike price, the option is “out of the money” and I will not exercise the option.

As you can see, the mechanics of options depend on the market price compared to the strike price.  No one would ever exercise options “out of the money,” because they would have to pay for the stock at a price higher than the market price.

While employee options have similar mechanics to buying and selling options on the market, there are many differences.  Do not use this as a guide to buy and sell options.

I made a bad stock trade this morning.  There, I said it.

Given that, I still made a bunch of money, but had I not let emotions get involved I would have made more money.  Here is the story:

I bought BRK.B about a month ago for $3,404 per share.  Over the last month is dipped down below $3,300 and slowly came back.  I bought it because I knew it was going to split 50:1 in the near future, and I wanted to capitalize on the price increase I (correctly) expect would happen.

Yesterday the split was announced.  The stock was way, way up.  This morning it split.  It went up more.  The market opened, it went up more.  I put in a stop order, it touched it for a second and went up more.  So, I locked in a profit of over $200, but it could have been more.

I traded on emotion.  I was so excited that I was right, I had to lock in my profit shortly after the market opened.  That was around 9:45am Eastern, 15 minutes after the market opened.  Had I been patient and set things up correctly, I could have made an extra $100.

But then it went back down.  I ended up buying it back for .80 less than I bought it for.  Good deal right?  I did it again.  I got impatient and sold it for a modest gain.  Had I been patient, and let emotion take a back seat, I would be up an extra .50 per share right now.  That is a lot with 50 shares.

So, I made about $220 after trading fees.  Not a bad day.  If I could do that every day, I would be in pretty good shape.  But I did learn a valuable lesson.  Be calculated and leave emotion at the door when you are buying and selling stocks.

I have been doing some research on a stock for the University of Denver endowment fund, as I am enrolled in a course where we make investment decisions for a $500,000 equity fund.  I made a good find and thought I would share it with all of you.  I plan to purchase this stock in my personal portfolio and to recommend a 1,000 share purchase for the fund.

The stock is World Wrestling Entertainment.  Don’t laugh, this company is very serious and is doing very well.  So well, in fact, that they are paying a 9% dividend.  I am in the camp that dividends should be reinvested until retirement.  In that case, your reinvested return in tax free until you sell it.

How can they pay so well?  WWE is a diversified entertainment company.  The main product, of course, is wrestling.  However, that business has launched an empire of products creating revenues and profits.  From cable and pay-per-view revenue, ticket sales, video game licenses, book publishing, a record studio, a movie production company, merchandise sales, web revenues, and toy licenses, WWE is is earning $500 million per year, of which about $50 million is profit.

I don’t mean to sound like an advertiser, but I am bullish on the stock.  The weak economy means less vacations and more TV.  More TV is a good thing for the WWE.  Stay-cations (vacation time spent at home) also helps the wrestling business, because people are both watching the shows and going to the reguar live events around the United States and Canada, which are not limited to the weekly Raw, SmackDown!, and ECW programs.

The risk with this stock is that revenues would decrease, spurred by a number of causes.  If a major wrestler, such a John Cena, were to be injured, many fans may stop watching.  However, the company has managed to succeed despite the departure of Hulk Hogan, Stone Cold Steve Austin, and The Rock.  In addition, new personalities such as Kofi Kingston prove that the WWE farm system (similar to AAA minor league baseball) is continuing to produce top level talent.

My analysis gives a target price of $23 per share.  For a stock trading at $16 with a 9% dividend, I call it a buy…  If ya smell, what Eric, is cooking…

Also, a quick thanks to FrugalTrader for including Narrow Bridge in this week’s carnival of personal finance, hosted at Million Dollar Journey.

Update 1/21/2010: I bought the stock this morning at $15.80 per share.  Here we go!

I don’t recall ever going over my stock portfolio in detail.  I thought you all might be interested in what stocks I own and why I own them.

My Company Stock – $2,600 market value.  Paid $1,980.

• I purchase my company stock for a 15% discount.  That is an amazing hedge and it has turned out to be a solid investment over the last two years.

Walmart (WMT) – $223 market value.  Paid $202.

• This was one of my first investments, hence the low value in the portfolio.  Walmart is the largest retailer in the world and has performed solidly over the last several decades.  The company continues to expand internationally and works to cut costs and increase sales volume.

General Electric Company (GE) – $198 market value.  Paid $197.

• This stock has been a relatively weak performer for me, but I did buy it right before a major drop.  It has come back into the green for me, so I can’t complain.  I believe the core businesses of GE are powerful and will continue to grow in the future.  Now that the capital markets are opening back up, GE Capital will begin to perform better as well, leading the whole company to growth in the long run.

Home Depot (HD) – $569 market value.  Paid $541.

• Home Depot is another strong retailer.  When the economy is down, HD will do well because so many people will try do it yourself projects to save money.  When the economy is up, it is a top destination for repair workers.  Only one major direct competitor remains (Lowe’s) and the company has growth potential around the world.

Berkshire Hathaway (BRK.B) – $3,275 market value.  $3,404 paid.

• Aside from being run by the “Oracle of Omaha”, Berkshire Hathaway is one of the most admired companies among investors.  Warren Buffet has led this company to amazing achievements and continues to lead the markets through his value investments.  BRK.B is planned to split 50:1 in January, bringing the stock price down to around $60-$70 per share.  I believe that the stock will rise dramatically when it becomes affordable to the average investor, not just people willing to pay well over $3,000 per share.  While this is not a value investment thesis, I am confident that it is a good bet.

My Watch List: WWE, MO

These investments are all in my portfolio and all opinions here are my own.  If you decide to buy these or any other stocks, you risk losing financial value.  Only invest what you can afford to lose.  I am not responsible for your investment losses (though I would love credit if you do well).

If you have ever bought or sold stock, you know that you have to do so through a stock broker.  The stock broker has access to sophisticated systems that link in to a series of exchanges that execute the trade.  Most of us never think about those systems and exchanges, but I was just there and I thought it was interesting.  Here is how a stock trade works from the buyer side.

New York Stock Exchange, 1930

So Joe Investor decides he wants to buy a share of Citigroup, which might not be so advisable today.  Citigroup’s ticker symbol is C.

In the old days, Joe would call up his stock broker and say, “Mr. Stock Broker, buy me 100 shares of Citi.”  At that point, the broker would call his trading desk and tell them to buy 100 shares of Citi for Joe.  The trading desk would call their floor trader at the New York Stock Exchange, and that trader would go find someone who wants to sell 100 shares of C.  Those people would meet at a spot on the floor where a specialist is posted for that stock.  The two traders would agree on a price.  If no one was selling, the Joe’s trader would just buy the stock from a specialist who keep an inventory of C in case anyone wanted to buy it but couldn’t find a seller.  Once an agreement was made on the price, the trade would take place and Joe would be the proud owner of C.  Joe’s broker would keep the stock in his account until he wanted to sell it or transfer to another broker.

Now, things are a bit different.  If Joe wants to buy a share of stock, he logs on to his stock broker website.  If he wants, he can still call, but the fee for doing that is usually about $20 higher than doing it online himself.  If Joe knows he wants C no matter what the price is, he can just type in that he wants to enter a market orderfor the stock.  At this point, the computer system will link into the NYSE-Euronext system and look at current sellers of C.  The system matches buyers and sellers automatically.  For small orders, this all happens automatically with no human intervention.

The order system is best visualized through the image on the right.  Just click on it to make it larger.  This is the active trading screen for Charles Schwab’s Street Smart, the program I use to monitor stocks live.  If you have a large account it is free, otherwise there is a big fee.  The screen, and similar ones at trading desks and Bloomberg terminals around the world, lets you see current bid and ask prices.  When they meet, a trade executes.  In this screen, you can see recent trades in the colored boxes.

Once the trade executes, your stock broker’s system will credit the shares to your account.  This generally takes two or three days to happen, as there is still a settlement lag time for the assets to transfer from the seller’s account to the seller’s broker to your broker to your account.

If I didn’t confuse you enough, some trades still can happen between two people, but those people must enter the trades into the computer system.  New shares of stock are distributed through an IPO and involve pre-orders through designated brokers.  Each stock exchange also has a separate system.  The NASDAQ and NYSE cannot trade each other’s stocks, but the NYSE and Euronext have merged and can trade each other’s stocks.  There is a lot to know.

How does this really impact you?  It does not unless you work on the stock market or are a serious active trader.  Either way, it is good to know how the system works.  You can impress your friends telling them about the bid-ask spread over drinks tonight. (Disclaimer: Unless your friends are nerds they will not think this is cool.)

An Picture of the Elusive Eric at the NYSE

If you think I missed something or have any questions, feel free to let me know in the comments.

Have you ever heard about people making, or losing, a lot of money quickly by trading on margins?  If you wondered what that means, grab your reading glasses and some popcorn.  It is time for Margin Trading 101.

Investopedia gives a good introduction to the idea of how margin trading works on the surface:

Imagine this: you’re sitting at the blackjack table and the dealer throws you an ace. You’d love to increase your bet, but you’re a little short on cash. Luckily, your friend offers to spot you $50 and says you can pay him back later. Tempting, isn’t it? If the cards are dealt right, you can win big and pay your buddy back his $50 with profits to spare. But what if you lose? Not only will you be down your original bet, but you’ll still owe your friend $50. Borrowing money at the casino is like gambling on steroids: the stakes are high and your potential for profit is dramatically increased. Conversely, your risk is also increased.

When you trade on the margin, you are borrowing cash from the brokerage firm to use in the stock market.  To trade on margins, you will need to be approved by your brokerage.  I would not do this unless you are super rich and can afford to lose 75% of what you borrow.  I would never short sell or buy anything other than large cap equities (stocks), but that might just be because I am afraid of losing everything I have.

When someone is setup for margin trades, they are given a limit (like a credit limit) and terms for what is essentially a loan.  To explain how it works, I will give an example of what an investor might go through when borrowing and investing on the margin.  These are completely made up numbers and do not necessarily represent fair or realistic terms.  I am just using round numbers because they are easy:

Joe Investor has an account at Online-Broker-Company (OBC).  Joe has a portfolio of $500,000 in an account at OBC that is invested with $400,000 in stocks, $50,000 in bonds, $10,000 in options, $30,000 in mutual funds, and $10,000 in cash.  Joe has had the account with OBC for five years and is an active trader (10+ trades per month).

Joe is doing some fundamental analysis and finds that stock XX is worth $20 per share, but is trading at $10 per share.  He also finds, using technical analysis, that the stock is likely going to trend upward over the next few days up to $17 per share.  Because he only has $10,000 in cash on hand, and he is certain of his estimates, Joe borrows funds from OBC that allow him to invest as much as possible into the stock.

Joe is required by OBC to invest 20% of his own funds for any margin buy, that is called the margin requirement.  Therefore, Joe can borrow up to $40,000.  Joe is approved by OBC for the margin purchase and is allowed to purchase $50,000 in stock XX with the $10,000 in his account.  He is also required to maintain a portfolio of at least $50,000 at the company as collateral in case the stock price goes down to zero.  He is considered to be 80% leveraged at this point.

The stock goes up to $25 per share and Joe gets greedy.  He could sell the stock and take the $15 per share, or 150% profit, and leave the transaction that cost him $10,000 with $125,000.  Joe doesn’t.  He decides, despite his analysis that the company is worth $20 per share, to stick it out.

The next day company XX goes bankrupt.  No one saw it coming.  The stock plummets in one hour to $1 per share.  All of a sudden, Joe’s $50,000 investment is worth $5,000.  He not only lost his own $5,000, he owes OBC $40,000 that he borrowed.  OBC will initiate a margin call, which is a request for Joe to give the firm the cash needed to bring his margin rate back to 20%.  Because of the large loss (90%), he has to come up with a lot of cash quickly.  If he can’t, OBC will sell $35,000 of Joe’s other investments and take his $5,000 cash to cover their loss.

This example is extreme, but it is possible.  Margin trading can give you a huge payday or a huge loss in very little time.  Your investment company is not the mafia and will not cut off your hand or kill you for losing their money, but you are legally responsible for paying them back.  If you try to take your assets and run, they can sue you, and will win, for the amount of their loss.

If you have something to add or any questions, please let me know in the comments.  If you enjoyed the post, consider following the blog by e-mail (using the form on the top right of the screen) or RSS.  Also, take a look at the well written comments that explain some of the complexities of margins in more detail.

If you ever watch CNBC or read about investing, you have undoubtedly heard about risk.  This post focuses on what investment risk means and how you should look at risk when investing.

Investment risk is generally measured with beta.  If a stock has a beta of one, the risk is equal to that over the overall market.  Higher beta means higher risk.  If you look up any stock on Google Finance, the beta is given at the top of the page.  Toyota, for example, has a beta of .72.  That means it is a low risk stock.  Ford Motor Company has a beta of 2.57, which means it is more volatile and more risky.

But how does that impact you?  If a stock has low risk, it will probably not go up or down very much.  If a stock has a high risk it could take a big swing either way.  There are two major reasons investors have to look at risk.  First, investors have to know how risk averse they are.  Second, that have to match that risk with return.

I am a little risk averse, but I am still young so I can afford a big swing in my portfolio.  My stocks have a beta of .20, 1.43, .98, and .64.  If weighted evenly, I have a portfolio risk of .81.  That means my portfolio will be slightly less volatile than the overall stock market.  With that level of risk, I would expect my gains, or losses, to be a little less than the overall market.

What does risk have to do with return?  As I said in the previous paragraph, risk should be proportionate to return.  If you invest in treasury bills, you have virtually no risk, and will get a little return.  US government securities are considered the closest investment in the world to “risk free.”  That is why US t-bill interest rates are considered the “risk free rate.”

Large corporate securities for established companies, called blue chips, are the second least risky investments, not including foreign treasury securities.  Blue chip stocks, such as those included in the Dow Jones average, generally have low risk.  One major measure of corporate risk is the bond rating system.  AAA, AA, A, or BBB bonds, are investment grade.  BB and below are considered junk bonds.  Like with other investments, high grades are less risky and give lower returns.  Moody’s and Standard and Poor’s are the most well known bond rating agencies.

Rather than keep rambling on, I will open up the floor (comments) for questions.

The big news this week in the financial world came out on Monday morning at 8:00am Eastern time.  General Motors declared bankruptcy.  This means a lot for the company, employees, debt holders, and shareholders.  This post will look at the impact on current debt holders and stock holders.

Let’s start with debt first because it is easier to explain.  When a company goes into Chapter 11 bankruptcy, a judge can eliminate or reduce debt.  If you are a GM bond owner, this will directly impact your future returns.  That $1,000 you were expecting at maturity: not gonna happen.  Your interest may be slashed too.  You will be lucky to get anything back in the end.

Now for the stock.  Lets say GM has 1,000,000 shares of stock outstanding.  If you own 10,000 shares, that .001% of the company.  When the government gave GM money, they were granted an equity share, lets say 1,000,000 new shares.  Now there are 2,000,000 shares outstanding, but you still own 10,000.  You now own .00005% of the company, or half of what you did before.

At GM, the situation is much more dire than the example above.  The shareholders ended up going through a dilution well over the 50% above.  The United Auto Workers were given 17.5% of the company, along with 55% of Chrysler.  The US government gets 60%.  The 22.5% left over, that gets divvied up among the current shareholders.  That means every 5 shares before is like buying 1 share today.

Even worse…  GM was de-listed from the stock exchange.  Now buying and selling the stock happens on what are called the pink sheets.  Pink sheets are far less liquid (harder to sell).  Each share was listed at $0.08 at market close today (June 3rd).

If that is confusing, please ask questions in the comments.

If you are looking for a fun, competitive way to get involved in the stock market with no risk, you might want to try out a stock market game. There are many out there, but my personal favorite is Investopedia.

This can be a great method to try out new investing strategies. While you do not get the real gains from good picks, you do not risk the losses of a bad decision.

Signing up is free at Investopedia.

I just read an interesting article on investment options. Investors have many vehicles to choose from, but are limited to two main options when dealing with corporate financing. Those options are stocks (equity) and bonds (debt).