Page 139 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 4. The Stakeholders 125

Investors may choose to buy or sell stock at either market price or a prescribed price.
Instructions to a broker for a market order mean to buy (or sell) stock at the current market
price. A limit order prescribes the price of the transaction. Believing the stock is going to go
up (and wishing to catch it before it falls), an investor might ask the broker to sell the stock
at $80, the current price being $75. Conversely, a limit buy would be setting a price below
current market, believing it is going to go down—for example, setting a limit order to buy
at $70, the current price being $75. Limit orders may be overtaken by other events (e.g., a
market run-up or sell-off, which could make the decision a poor one).
Stock purchased by a broker can be put in the name of the individual and held by the
broker, or the certificate sent to the new owner. Conversely, the stock could be in the name
of the broker, but held for the person. Such a designation is called street name.
Investors typically will buy stock through a broker, paying cash for the amount of the
stock plus a broker’s fee. The fee ranges considerably based on the type of broker. One can
expect to pay the greatest fee to a full-service broker, who provides research and other
services, and the lowest to a discount broker, possibly one on the Internet. It is expected that
research analysts who recommend buy/hold/sell positions on stock would not have their
income based on investment banker decisions that the analyst could influence by his or her
recommendations. However, some decide to leverage their available assets by buying on
margin, in other words, paying only a part of the cost, the remainder paid by a loan from the
broker. The Federal Reserve Board Requirement (since 1974) has been that the purchaser
must put up at least 50 percent of the fair market value (FMV) in cash and that the loan
cannot be for more than 50 percent of FMV. After purchase, investors are required to have
at least a 25 percent margin; that is, the difference between the value of the stock and the loan
amount cannot be less than 25 percent of the stock value. If it is less than 25 percent, the
borrower has a limited period of time, ranging from hours to several days (depending on the
extent of drop in stock value and the policy of the brokerage house), to restore at least a
25 percent margin. Should the investor not cover the margin, the stockbroker will sell stock
until the margin is covered.
This is illustrated in Table 4-7, where the executive buys 100,000 shares of Brucell stock
at $50 a share, using $2.5 million of own money and borrowing $2.5 million from the stock-
broker. Everything is fine until the stock drops to $30 a share, at which time the broker makes
a margin call to restore the 25 percent margin. Either the investor sends the broker a check
for $250,000, reducing the loan to $2,250,000 and a margin of $750,000 (25 percent of the
stock value), or the broker sells enough stock to achieve a margin of 25 percent or more—in
this example, 35,000 shares. This is illustrated in Table 4-8.
In addition to those investors who choose to directly buy or sell stock, there are those
who buy and sell options. Options are contracts with the right (but not the obligation) to buy
or sell 100 shares of a particular company’s stock at a stated price by a prescribed date.
Purchasing a call option gives the holder the right to buy the stock at the stated price within
the prescribed expiration period. A put option gives the buyer the right to sell the stock at a
specified price with-in the stated period of time. A collar is a put and call on the same stock,
hedging against a drop in the stock price with acceptance of a maximum rise. The price is
called the exercise or strike price. If the price of the stock is below the call or above the put, it
is out of the money. Conversely, if the price of the stock is above the call or below the put, it is
in the money. Option contracts are typically for brief periods (e.g., one to nine months), and
each contract is for 100 shares.