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Choosing a Broker

by Shawn Wolff  


Part I

Last week, when I talked about trading tools, it lead to a lot of email asking about brokers. So I thought I would share some of the things I find important in choosing a broker.

Deciding which broker is right for you will depend greatly on your situation and your trading or investing style. The first decision you need to make is between a full service broker, or a do-it-yourself discount broker. Full service brokers are there to guide your investment decisions, as well as execute them for you. The extra service comes at a much higher price though, so I would certainly want to know how my broker was performing versus the market’s average. They are also geared more towards those with larger portfolios, particularly in the last few years as the brokerage industry has felt the crunch of a dropping market. Merrill Lynch for example, barely breaks even on accounts below $250,000. So a full service broker might be a better decision for someone with a lot of money, and not a clue of what to do with it. My argument against that however would be, if you have a large amount of money to invest, you have a responsibility to educate yourself and get a clue. You are the only person with an unbiased interest in your investments, and you have the largest stake in your future.

The next option is the discount broker. This is the stripped down version, with little or no guidance. Deciding on the discount broker route, you are taking your future into your own hands. You have to become your own little hedge fund. You are responsible for stock research and analysis, market strategy, your own upgrades and downgrades, your own money and risk management, and the actual execution. You are in essence replacing an entire team. And that is a big job, not to be taken lightly. But no one said investing was easy, and whether you make the decisions, or leave them to someone else, you should be equally informed and involved.

Once you have opted for a discount broker, you have to choose one, and that isn’t an easy task in this competitive field. There are a lot of discount brokers out there. After years of trying different brokers out though, here are the priorities I have, and the things I have found to really matter the most.

1. What type of service am I going to get?

Often we make commission prices our first priority. Its human nature to look for the best deal. And as long as everything is running smoothly, it won’t matter what type of customer service your broker has. But when something goes wrong (and it will happen), it can cost you a lot more than you ever saved in cheap commissions. And in those circumstances, I want a broker who will answer the phone promptly and courteously, and make it right. I don’t want to be put on hold. I don’t want to be asked my account number 20 times while my stock falls 2 dollars. And I don’t want excuses. So before you make your choice, try out the customer service line a few times and see how long it takes to get an real person. Also ask around and talk to current customers. Other than handling problems, how good are they are getting hard to find shares available to short?

2. How are the executions?

It is very important to understand the difference between Direct Access Trading and Web Based Trading.
Web Based Trading involves logging in through a web site and entering trades through a web browser. By the time investors load a web browser, login, confirm the order and send it, a few minutes might have gone by. The stock price could quite possibly have turned against them or they could have received a poor execution or no execution at all. The order is probably executed according to the broker's choice of venue even though the price received might not be the best available. For this reason, many Web Based Trading systems are not equipped to service active investors. Most are simply not fast enough and do not offer as many execution capabilities/venues.

Direct Access Trading routes trades to the exchange, market maker or ECN of the client’s choice, not the broker’s. The trade is not done through a web-browser. Clients are logged directly into their broker’s DAT system. This offers the opportunity for better and faster executions as well as the opportunity for price improvement.

For my retirement account, I am using Etrade. They offer a nice array of retirement plans that fit my needs, and because my trades are a bit longer-term and less numerous, the executions are not as critical. For my daytrading however, I am currently using Shoreline Trading. My reason is the service, I can get the Redi platform through them with Direct Access Trading, and they do not internalise or accept payment for order flow. I want to know that my broker has my best interests at heart, and that I have the best tools available.
The important thing is to know what kind of trader you are and what your needs are. Know what your broker is doing with your order. Know what happens when you press the buy button. Know if your broker is selling your trades to a 3rd party for payments. And finally know all of your options. The more informed you stay, the better chance you have of competing with the “professionals” because, the “professionals” probably know the answers to all those questions.

3. What are the fees?

My last consideration is the fees involved. This not only means commissions per trade, it also means looking for hidden costs. Be sure to inquire about things like account minimum balances, fees for transferring assets, account inactivity fees, and annual fees. Also check the margin interest rate if you plan on going on margin at all.

As always, the answer to any investment decision is education, and your choice of broker should be no exception. So dig in there and find out as much as you can before signing on the dotted line.

Part II

My last article I discussed choosing a broker and lightly touched on the topic of payment for order flow.
This is a practice that has been around for years, generally in equities and options, and although it has reportedly diminished somewhat in the last few years, it still continues today. Because of intense competition for order flow, participants began offering direct and indirect financial incentives for brokers to route their customers' order flow to them.

A direct incentive is a cash payment referred to as “payment for order flow”. Exchanges or market-makers will pay your broker's firm for routing your order to them. In this way, your broker can make some extra money from executing your trade. They often pay up to $.015 per share for transactions directed their way. When bunched together with many other orders, the 3rd party firm paying for your order, can oftentimes make the “spread” (the difference between the bid and ask) on the orders it receives from your broker.
In addition to direct cash incentives, your broker may also profit indirectly from your order by “internalising” (trading it themselves as a counter-party), or routing it to affiliated parties. They may also be involved in reciprocal order routing agreements.

The problem with this practice is that all this financial incentive for detouring your order creates a conflict of interest between the broker’s responsibility for “best execution”, and the appeal of lining his own pocket. The result is lower quality of executions. It may also be possible that this practice creates markets that are less efficient, hindering fair and effective price discovery.

Amidst some controversy, the SEC released a study of the situation in 2000, but no action was taken. So the practice has continued, and this year the Chicago Board Options Exchange (CBOE), the nations largest options exchange, announced the reinstitution of their exchange-sponsored payment for order flow program.

So what does this mean to us as retail traders? The difference in your executions might only be a penny. What’s a penny here or there? Well it depends on what type of investor or trader you are. If you are making 10 executions a year, and they are for long-term positions, the penny you might lose on the execution won’t make much of a difference. As we struggle to level the playing field for day traders, swing traders, momentum traders and scalpers (the same styles of trading used by the specialists) theses pennies become more and more important. If you are making 10 trades a day, with 2000 shares each trade, the difference might cost you 200 dollars a day or more. Hedge funds will not put up with payment for order flow, so why should we, as individual active traders?

How do you know whether or not your broker is accepting payment for your orders? In November 2000 the Securities and Exchange Commission adopted Exchange Act Rule 11Ac1-6 which became effective on July 2, 2001. The rule requires all broker-dealers that route orders on behalf of customers (nondirected), to prepare quarterly reports that disclose the identity of the venues to which it routed orders for execution. A non-directed order is one in which the customer does not specify the market center to which the transaction shall be routed. In addition, the nature of the broker-dealer's relationship with the market centers receiving the non direct order flow and any material aspects of internalization or payment for order flow arrangements are to be disclosed. Look at the backs of your confirmations and monthly statements!

Some, but not all, brokers take payment for order flow. Some of those that currently do are Etrade, Scotttrade, Ameritrade, TD Waterhouse, Charles Schwab, and Brown & Co. Here are some examples, according to data for the quarter ending June 2003. Around 99% of all NYSE stocks traded at Etrade were nondirected, which means the customer relies on Etrade for the best place to send the order. Etrade decided to send less then 1% of these orders to the NYSE. Etrade was paid for sending 82% of these orders. Scottrade sent 66% of all NASDAQ stocks that were nondirected to Knight Capital Markets, and 16% to Scottrade’s principal account. Around 98% of all NYSE stocks traded at Ameritrade were nondirected. Ameritrade chose to send less then 7% of these orders to the NYSE, but sent 58% to Knight Capital Markets. Of all the NASDAQ stocks traded at Charles Schwab, 99% were nondirected. Charles Schwab decided to send 95% of these orders to an affiliate called Schwab Capital Markets LP. The list goes on and on similarly. Let me know if you would like the links to that data.

At a time when you have to choose between paying $5.00 a trade to a firm that may sell your order flow, or paying slightly more and having total access to the markets, your decision is a very important one. The type of trader or investor you are will determine what is more important. And remember, no matter how you trade - education is the key.







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