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IN THIS CHAPTER

❯❯ Discovering broker types

❯❯ Finding out about broker service options

❯❯ Sorting through different types of brokerage accounts

❯❯ Deciphering trading rules

As an individual, you can’t trade stocks – or bonds, or options, or futures – unless you have a broker or are a broker yourself. That doesn’t mean, however, that you have to work with a human being to trade stocks. Online brokers and direct‐access brokers enable you to make trades electronically, so you never need to speak with a human being for these processes unless you’re having a technical problem.

The differences among brokers are based on prices, services, and special capabilities. High‐volume swing traders and day traders typically require the services of a direct‐access broker, while position traders can and do trade successfully with more traditional discount, online, and full‐service brokers. In this chapter, we help you understand the brokerage options that are available, the types of accounts you can establish, and the basic trading rules you must follow.

Why You Need a Broker

Unless you plan to get your brokerage license from the National Association of Securities Dealers (NASD) and set up shop yourself (which is hard – and expensive – to do), you need to work with a broker to be able to buy and sell stocks. How you choose a broker is based on the level of individual services you want. The more services you want, the more you pay for your ability to trade.

As an individual, you can open your account with a brokerage house, but if you work with a human being, that person is considered a broker. Brokerage houses or brokerage services are also usually referred to as brokers for short.

For now, just be aware that on one side of the spectrum is the full‐service broker who does a lot of hand‐holding and offers stock research and advice and other human‐based services. When using a full‐service broker, you pay a significant commission for each stock trade. In the middle are discount brokers that offer fewer services but charge less per trade. On the opposite side of the spectrum are direct‐access brokers, who offer few human‐based services and instead provide extensive trading platforms so you can trade electronically and access the stock‐exchange systems directly on a real‐time basis.

Exploring Types of Brokers and Brokerage Services

Before you can pick the type of broker that best fulfills your needs, you need to understand the kinds of services that each kind of broker provides. After you gain an understanding of your options and select the types of services you want, you then need to carefully research each of the brokers that match your needs. Within each classification are good and bad brokers. We give you the tools for researching brokerage firms in the sections that follow.

Full‐service brokers

If you want someone to assist you with buying decisions and implementing those decisions, you need to check out full‐service brokers. They offer extensive research and other services. Usually, they call you with trading ideas. All you need to do is say yes or no. You pay a transaction fee for trades plus a commission percentage based on the dollar volume. You can invest in stocks, futures, options, bonds, mutual funds, money‐market funds, and variable annuities. You can work with a full‐service broker by telephone, mail, fax, or Internet. Most have websites you can access for information, and many allow you to enter your own trades.

Here is an example transaction fee schedule for one of the better‐known full‐service brokers (others can be as much as twice as high):

Alternatively, some full‐service brokers do permit you to make all the trades you want per year for a fee of 0.30 percent to 2.5 percent of the total assets in your brokerage account. Using language common to traders, that’s 30 to 250 basis points. You have to have more than $10 million in an account to get the lowest fee. Traders with less than $100,000 pay closer to the 2.5 percent of assets to access the unlimited trading features.

Just because you choose to use a full‐service broker doesn’t mean you can just sit back and let your money grow after placing it into an account. Brokers make money on commissions for the exchange of stocks. If they have no transactions during a given month, they don’t get paid. Unscrupulous brokers recommend trades to their customers to generate new commissions even when those decisions are not necessarily the best investment advice for their clients. This practice is often referred to as churning.

Even the research arms of many full‐service brokerage houses are scrutinized by the Securities and Exchange Commission (SEC) primarily because their analyses didn’t accurately reflect the values of stocks in companies that used the firms’ investment‐banking capabilities in the past. Analysts tend to see their firms’ clients through rose‐colored glasses when providing research reports, especially when their firms make a lot of money by providing investment‐banking services to those companies. We talk about changes that have been implemented to improve analyst services in Chapter 7.

Just because you choose to work through a full‐service broker doesn’t mean you can sidestep doing your own research. You always need to perform due diligence, independently researching your stock purchases. Although you certainly can use the research arm of your brokerage firm, it shouldn’t be your sole source of research on any stock you’re thinking about buying or that you already hold.

If you’re planning to be a trader, then do your own research and implement your own trading strategies. Why pay for the services of a full‐service broker? We really don’t recommend that you waste your money on the additional costs of maintaining a full‐service brokerage account or paying the high transaction fees and commissions.

Discount brokers

Many discount brokers offer the same services as full‐service brokers, including research. The big exception is that you don’t get individual attention or unsolicited advice on what to buy or sell. Some discount brokers send out monthly newsletters with stock recommendations; most don’t trade futures or sell variable annuities. You can access a discount broker by telephone, mail, fax, or Internet. To get the lowest fees on trades, you need to do your own trades by accessing the broker’s website.

The big difference to you, as an individual trader, is that you can save a lot of money on trading costs, provided you know what you’re doing and you understand the language of stock trading. Transaction fees for online trades can range from as low as $5 up to about $30 with a discount broker. If you want special services requiring a broker’s assistance, you can work with a human being. Depending on the discount brokerage firm and the level of service required, fees can range from $25 to $50 per trade. Some discount brokers provide broker‐assisted trades using a commission rate schedule similar to the ones offered by full‐service brokers, but it has lower fees per trade. If you get involved in more‐complicated trading transactions that require human assistance, costs can rise significantly. Anytime you’re planning to use a broker’s assistance, be sure you understand any additional costs that may be charged to your account for that assistance.

Direct‐access brokers

If you want to bypass the traditional brokers and trade directly through an exchange or market maker, you need to open your account with a direct‐access broker so you can use one or more of the electronic communications networks (ECNs) to make your trades. Traders usually download software onto their PCs so they can access the ECN directly using their Internet connections.

Traders using direct‐access brokers typically get real‐time NASDAQ Level I quotes, which show the latest bid and ask prices, quote size, last trade, and volume.

Direct‐access brokers also offer NASDAQ Level II access. NASDAQ fees are higher for Level II, and the brokerage may also charge an additional fee for this type of access. In addition to what you see in a Level I quote, you also find the number of market makers participating in the market for any one stock.

A NASDAQ Level II quote screen shows the best bid price and the best ask price for specific stocks from participating market makers. All the bid and ask prices are ranked from best to worst. Some direct‐access brokers combine NASDAQ Level II information and ECN book data to show the complete market depth for a specific stock. The ECN book isn’t a printed book like you would expect to find on a bookstore shelf. It’s a compilation of all the trades and the bid and ask quotes available on all the electronic networks.

Traders can review the quotes and select which market maker or ECN to use for each transaction. Most full‐service and discount brokers make that choice for you when you’re working with them. A few discount brokers are providing access to ECNs.

When working with direct‐access brokers, one key difference is that the software you use may reside on your own computer and not on your broker’s server, which greatly accelerates the speed at which you can trade. Again, some discount brokers provide software to enable you to receive direct raw data on your home computer, but their software isn’t as sophisticated as what direct‐access brokers have to offer. We cover software issues in detail in Chapter 4.

We often talk about how you can miss trading at the prices you want, especially in fast‐moving markets. Well, having direct access doesn’t guarantee that you won’t miss a price, but your chances of catching those prices are better because you don’t have to wait for pages to download from your broker’s server. Of course, for this advantage to work for you, you must have high‐speed Internet access, which can include DSL, cable, or satellite access.

Working with a direct‐access broker gives you a steady stream of raw financial data – the actual trades, current bid and ask prices, trading volume, and market statistics. The trading software that you load onto your computer determines how this data is organized and presented on your computer monitor. Providing better access is how direct‐access brokers distinguish their services from other brokers.