THE OPTIONS COURSE- Choosing the Right Broker

THE OPTIONS COURSE


Choosing the Right Broker

Selecting the right broker and placing orders correctly are essential elements in your development as a successful trader. In the beginning, the entire process may seem quite complex and perhaps more complicated than you thought. Don’t waste time worrying about all the different issues involved. It all boils down to one intention: You contact your broker and explain to him or her what you want to do. That’s it. However, it is important to realize that each step leaves room for error to occur. 

You can’t control all the steps, because once you place your order the rest of the process is handled by your brokerage firm and the exchanges. At the same time, however, you can control which broker you’ve selected to help you. Remember, a good broker is an asset and a bad broker is a liability. It is vital to take the selection process very seriously because you don’t want your broker to make you broker! A major mistake many people make when they first begin investing is to listen to their broker’s advice without question. Why do they do this? 

Perhaps because many people have been brainwashed to believe that just because a broker has a license, he or she must know how to make profitable investment decisions. As in any profession, there are top-notch professionals as well as others who have missed their calling and should not be offering their services. The best advice I can give you is to be very selective in finding your broker. The first step is to decide what kind of trader or investor you want to be. No two investors are exactly alike. Some prefer to trade actively while others simply want to buy stocks and hold them for many years. Still others rely heavily on options. 

Trading and investing attracts all sorts of people, and each person has a unique approach to the market. What type of investor are you? Answering that question is an important first step when looking for a broker—someone who meets your specific trading needs. After all, there are more than 200 different brokers to choose from and each is unique in terms of commissions, choices of investments, research, and so on. There are, however, only a handful of brokerage firms that most options traders choose to deal with regularly.

WHAT IS A BROKER?

A broker is an individual or entity who is licensed to buy and sell market-place securities and/or derivatives to traders and investors. In addition, brokerage firms must also be licensed and insured to accept customer deposits. A word of caution: It is a major misconception to believe that just because someone is licensed to take an order they have the knowledge to invest your money wisely. Just like there are bad doctors out there practicing medicine, there are many brokers who are not good at making investment decisions.

If you’re reading this book, chances are that you don’t need the help of a full-service broker, which is a type of broker that receives relatively high commissions or fees for offering investment advice. Instead, most options traders use self-directed brokerage accounts, or brokerage firms that serve as order takers rather than investment advisers. Commissions and fees will be greater at a full-service broker. A reliable broker is worth a great deal whether he or she is offering advice or merely executing trades. 

Finding a broker who understands a wide variety of markets and your trading strategies is relatively difficult, but, when possible, the relationship between client and customer can develop into a long-term and successful one. Remember, successful traders develop profitable trading strategies that require a broker who can execute orders with precision. Brokers are the intermediaries of trading. Building profits is the name of the game. 

The broker makes money whether you win or lose—the brokerage commissions will always be paid. Many traders choose to trade with discount brokers; this can be profitable as long as they are getting good executions on their orders. Brokers get paid to provide this service. They execute your orders and protect your interests. Many investors, especially beginners, try to find a broker with the lowest commission cost. However, an inexpensive broker can become an expensive broker overnight if mistakes are made each time the broker places your trade. It is imperative to balance low-cost commissions with prompt service and good execution.

Until 1975, the brokerage business was dominated by a relatively small number of large firms. But in May of that year, deregulation loosened the commission fee structures and discount brokerages began setting up shop. Since then three main kinds of brokers have dominated the playing field: full-service, discount, and deep-discount. All brokers get paid a commission each time you place a trade. The amount of this commission depends on what kind of service they provide.

Full-service brokers have higher commissions because they spend considerable time researching markets in order to advise their clients. Discount brokers have lower commissions because they simply act as an agent placing the trader’s order as well as facilitating the exit. Deep-discount brokers primarily trade for investors who trade in large blocks. They offer the lowest commission rates of the three. In the 1990s, online electronic brokers burst upon the scene offering the lowest commission costs ever via easy computer access.

THE RISE OF ONLINE BROKERAGES

The way people use the Internet to make investment decisions continues to evolve. It all started with the appearance of a handful of online discountbrokers in the late 1990s. Now a large number of online brokers are battling for traders’ orders. Full-service firms, which have seen an increasing number of clients gravitate toward do-it-yourself investing and online trading, have responded by launching their own web sites and recapturing some of those lost accounts. But the way people use the Internet to handle investments goes beyond the battle of full-service and online brokers. 

A number of new and innovative products have been launched and more are expected in the near future. Some products are designed to help investors make better asset allocation decisions and others are designed merely to simplify the investment process. Regardless of the specific purpose, the new Web-based financial services are all designed to profit from the increasing use of technology by the individual investor. The result has been a proliferation of new online products and an evolution in the way the Internet is used for investment decisions. Online brokerages provide a number of advantages over traditional full-service and discount brokerages. 

First and foremost, online brokerages have severely reduced their commission costs from the lofty levels set by traditional brokers. All brokers get paid a commission fee each time you place an order (or exit an option position). The amount of this commission depends on what kind of service they provide. Each transaction is called a round turn and costs as little as $10 (and the cost is getting lower) at an online brokerage and more than $100 at a full-service brokerage. Although generally much lower than their predecessors, online brokerage commissions and margin amounts vary. 

But don’t waste too much time fretting over a couple of dollars of commission when evaluating online brokers. Small difference in prices due to poor trade executions can cost you a great deal more, and an inexpensive broker can become an expensive broker overnight if they lose money each time they place your trade. Broker responsibilities may differ, but timely executions and good fills are still the most important part of a broker’s services. Bottom line: It may be desirable to match low cost with prompt service and good execution; but it is not always profitable to use the cheapest broker just to save a few bucks on commissions. 

Another major improvement comes in the form of information. Online brokerages offer real-time quotes, charts, news, and analysis as well as the ability to customize this information to fit your portfolio. Now you have the means to research stock tips immediately, read up-to-the-minute news as it happens, monitor the mood of markets throughout the day, and access option premiums for price fluctuations. The marketplace is alive and you’re right there with it. You no longer have to sit on hold waiting for your broker to tell you he’ll get back to you on that. 

Given the Internet revolution that has permeated almost every aspect of our lives, it is likely that you will consider using an online broker. To help you make the most of this decision, pay attention to the following points:

Trade online, but have a broker on standby. Some investors want the convenience of being able to make some trades online, but also have a specific broker to bounce ideas off. Full-service firms have answered their call. Responding to the increasing popularity of online trading and its low commissions, many of Wall Street’s big names are rolling out services that let investors trade online for discount commissions or a flat fee, but at the same time offer the services of a live broker for higher commissions. Similarly, many online firms provide clients with the ability to trade over the Internet or with a broker for an additional fee.

Online brokers are also recognizing the importance of having an online and traditional brick and mortar presence. Some firms like E*Trade and Charles Schwab have developed online trading platforms and physical locations that investors can visit and do business. If you’re the type of person who likes to go into the bank rather than use the ATM, you might want to check in the yellow pages to see which brokers have branches in your area.

• Options specialists. Some brokerage firms like Thinkorswim, Wall Street*E, and OptionsXpress specialize in dealing with options traders. These firms provide sophisticated trading platforms with the ability to execute almost any conceivable options strategy on- or off-line.

Screen for trades. Are you looking for a site that will help you find that next big winner?now offer investors a way of screening for stocks based on a number of variables (P/E ratios, price-to-book, market value, etc.) in a matter of seconds.

Many brokers and other financial services firms are recognizing the changing needs of online investors. In response, some of Wall Street’s big names are using a combination of both online and full-service amenities to woo investors. Others are hoping to attract new accounts by offering financial planning as well as an amazing array of portfolio building services. The ongoing evolution in web-based financial services continues and serves as further evidence of how technology is changing our everyday lives.

QUESTIONS FOR POTENTIAL BROKERS

Remember, your broker is in the business of looking after your interests. Make sure you find a broker that is licensed to execute stocks and options or futures transactions. Most brokerage firms provide either stocks and options or futures, not both, because futures are regulated separately from stocks and options. Some firms, like Cybertrader, allow you to trade both, but you must maintain two separate accounts in order to do so. 

In either case, your chief concern as a trader should be to get the transaction executed as you desire and at the best price possible. Choosing the right broker is essential to your success. But how do you find the right one? When choosing a broker, review the following four points:

1. Does your broker really know more than you do? Your broker should be an asset to you, should have sufficient knowledge of the markets you trade and invest in, and be able to make first-rate suggestions to help you increase your profitability. As a novice investor, be very careful with your broker selection. Look for a broker who has knowledge about a wide variety of option markets, including margins, spread strategies, volatility, points, strikes, and so on. Interview potential brokers by presenting a specific trade to see if she or he can talk intelligently about it.

Can she or he define the market conditions, risk, potential return, breakevens, and so on? Ask the broker how much of a percentage of their revenue comes from options. Look for a broker with a similar risk profile as yours. Most importantly, make sure your personality fits the broker’s personality—you really have to be comfortable with their style and time availability. You should also find out if your broker’s backup assistants understand options as well. Inevitably, you will end up dealing with assistants, and they need to be knowledgeable about options or you will find frustration down the road.

2. Invest your own account. Information from your broker should be viewed as a potential opportunity, not as advice. Once again, ask your broker for suggestions, not advice. It is very important that you always take responsibility for your own profitability.

3. Do your own homework. Study, study, study. Continue to do your homework even after you’ve achieved success, because the learning process never ends when you’re in the investment field. The day you think you have learned it all is the day you should retire. Overconfidence leads to complacency and losses.

4. Always listen and digest before making any investment decisions. Remember, you can always call your broker back. When you call, listen to what your broker has to say, but never make an investment while still on the phone. End the call and put the phone down. Think about the information you have received and then do an analysis of risk and reward. If you still find the suggestion to be valuable, then call back and make the investment. My biggest mistakes were hasty investment decisions.

WHAT MAKES A GOOD BROKER?

Much advice has been given as to just what makes a good broker, and just what one must look for in opening a brokerage account. The key elements of most advice come down to the following issues:

Commissions. You want them as low as possible, but be careful—a low commission structure may mean that you don’t get the level of service you may want and need.

Minimum account size requirements. This can vary anywhere from $500 up to and above $25,000 to open an account. While the size of your trading account may limit you to certain low-requirement brokers, keep in mind that to open a marginable account (required for spread trading) there is a minimum $2,000 balance requirement beyond any options you own. Thus you must have a minimum of $2,000 in cash or nonmargined securities available before you even start to trade. Hence, a $2,500 opening balance would only permit you to enter a trade (or trades) with a net $500 debit position. Needless to say, this will severely restrict what trades can be placed.

Other requirements of the brokerage house. Check to see what other requirements may be in effect. For instance, how are good till canceled (GTC) orders handled, if at all? For instance, many houses will not enter a GTC order on a spread trade. If you want to trade this way, then special arrangements will have to be made for you (the broker will automatically reenter the trade each morning, etc.). You’ll need to adjust your trading style or find a different broker.

Speed and accuracy of fills. This is something that is very difficult to determine before opening an account, other than by talking with other traders. However, “good” is really in the eye of the beholder—if it is profitable for you, then it is good, regardless of what others may think.

Optionable and spreadable accounts available. In particular, make sure that in calculating margin requirements on your account that the brokerage house gives you credit for your long position as an offset to your short. You do not want the house to be calculating margin based on the short position only!

Experience in trading options in general and combination trades in particular. You will want your broker familiar with options, and hopefully, with option strategies, so that they can anticipate your needs.

Ability to fill the order between the spread. If you place your buy orders at the ask and sell orders at the bid prices, will the broker routinely get you a better price? If so, you can then place an order such that you will be filled, with the broker working the difference to get you the best price. Online brokers typically do not do this, as everything is placed electronically.

General comfort level with the broker. This is a very subjective point, but probably the most important. You must feel that the broker is looking out for your interests. After all, your broker has your money. Even if you’re only placing trades online, it is important to feel comfortable about the firm you are dealing with on a regular basis.

Once you have chosen a broker, however, the fun begins. As you are likely aware from your own business, there are customers or clients that you enjoy dealing with and others whose call you dread taking. Obviously, those whom you enjoy dealing with will get service beyond the minimum and will generally be happier with their experience than will the troublesome customers—so, too, in the world of brokers. Two personal experiences come to mind when thinking of good brokers. In one case, we had been discussing exiting a trade for several weeks. 

Finally, I put the order in. About three minutes later, I got a phone call from my broker, saying that no, she hadn’t filled the order, but rather had pulled it. It seems that after sending the trade to the floor, she overheard someone talking about a takeover rumor. On checking, she found that the stock was indeed in play, and in fact trading had been halted. On reopening, the shares gapped up about $5, and that is where I would have been filled had she not pulled the trade. By pulling it, she enabled me to watch the stock drift up about $15 over the next week, which turned an otherwise small loss into a very profitable trade. 

The second example is a situation where I got a call back from the broker checking to see if my trade was accurate. I normally use bull positions when trading, and I had inadvertently entered a bear spread on this particular trade. Upon checking, I found that indeed I had transposed my buy and sell options on the trade. It was my error, and could have been quite expensive. So, what will get you the best treatment? Besides common courtesy, the key factor mentioned by various brokers in an informal survey I conducted was that the customer has to have a plan, and has to articulate the plan with them. 

What do you expect from the account? What are your goals—retirement portfolio, current income, and so on? What risks are you willing to take? What types of trades do you like or dislike? Are there industries you want to avoid or to specialize in? Such information can obviously help them to recognize situations that may interest you. Reviewing your account periodically with your broker is also important. Obviously, as a trader, you will be in frequent contact with your broker regarding your trades, but periodically you should review your goals with your broker. 

If your trades are then deviating from your stated goals, the broker can better question if indeed this is what you really want to be doing. This, of course, would not apply if you were dealing only with an online broker. In that case, it will be up to you to review your goals and your trades to make sure you are staying on track. Knowing what you need from the broker and asking for specific information also looms high on the list of good customer traits. If you are on a fishing expedition and don’t know exactly what you need, or what you need is not absolutely critical for this instant, wait until after market hours for such discussions. 

In other words, be judicious with your broker’s time. In this same vein, ask questions when you are unsure. Whether it is a definition (a “chocolate milkshake” in Chicago is a different beverage than one in New York—i.e., different terms are frequently used for the same concept) or it is a new strategy, ask your broker to explain it. Don’t make guesses; your broker is willing to help. It is a lot easier to spend 30 seconds in explanation up front rather than trying to unwind some position you got into by not understanding what was happening.

The most surprising comment of my informal survey came from a brokerage dealing primarily in options, one where all of the brokers have actual trading-floor experience. The comment was that this broker preferred longer-term investors. He much preferred customers who had 90 percent of their investments in long-term positions and limited their short-term plays to less than 10 percent of their portfolio. “Short-term traders don’t last.” The worst type of account, according to one full-service broker, is the customer simply handing them a check and saying to “make me money.” 

With no direction, no understanding of risk tolerances, and no clear goals, it is almost impossible to satisfy such a client. Decision making is important on the part of the client. Clients who cannot make up their minds, clients who ask for advice and then go away to “think about it,” never returning with an answer, lead to frustration on the part of the broker. A final problem client is the one who expects much service, but then doesn’t trade with that broker—and instead goes elsewhere. Obviously this is a problem faced much more frequently by the full-service broker, but even the discount brokers seem to have such problems. 

Obviously the broker understands that they won’t get every trade, nor does every request for information result in a trade, but commissions pay them, so they expect some reasonable relationship between the amount of service delivered and the amount of trading through your account. Finally, talk to your broker. We will assume that you let them know when they make a mistake, but also let them know when they do a good job. Recommend them to friends and family when appropriate. Remember that by being a good client, you will soon find that most brokers suddenly get better. After all, “brokers are people, too.”

QUALITY OF EXECUTION

While many investors focus solely on the dollar costs of commissions when choosing brokers, there are other less obvious costs to be wary of. Specifically, when investors place buy and sell orders, the quality of the execution and the subsequent price at which the stock trade takes place are equally important to consider. For instance, if you place a market order to sell 500 shares of a stock and the broker fails to act promptly, the order might get filled for, hypothetically, $50 rather than $50.25 a share. In other words, a delay in executing an order when a stock is falling can cost you 25 cents a share.

Meaningless? Well, that amounts to $125 on your 500-share order. So if you are consistently losing eighths and quarters on share trades, who cares if the trades are commission-free? Arguably, the quality of a broker’s execution is more important than the commissions on trades. In fact, under federal securities laws, all brokers have a duty to execute orders at the best possible price. It is called the “duty of best execution.” Consequently, the Securities and Exchange Commission (SEC) has stepped up surveillance of online brokers because of concern over the quality of their executions. Some of the concern stems from a practice known as payment for order flow.

In order to understand how payment for order flow works, consider what happens from the time you submit your stock order until the time it is executed. Once the broker receives the order, they have a responsibility under the “duty of fair dealing” provision of the Securities Exchange Act to proceed promptly. At the same time, under the “duty of best execution” provision of the same Act, the broker is obligated to fulfill the order at the best possible price. With payment for order flow, this isn’t always the case. Rather than shopping the order around to competing market makers or electronic communication networks (ECNs), the order is sent to a wholesale market maker who, in turn, pays the broker for sending orders in their direction. 

In short, brokers are increasingly using preferred market makers who pay them for the buy and sell orders. Such arrangements allow online brokers to offer cheap automated trades because they also make money off the order flow. At the same time, large market makers, such as Knight/Trimark, sometimes handle more than 30 percent of the orders in a particular stock. As the high volume of orders comes through, the market makers generate profits from the difference between the bids and offers. There is no incentive for them to beat the prevailing market price. 

Therefore, by directing trades to market makers who pay for order flow rather than shopping the order around to competing market makers, the broker is not assuring clients execution at the best possible price. During a speech to the Securities Industry Association in November 1999, SEC governor Arthur Levitt noted, “I worry that best execution may be comprised by payment for order flow, internalization, and certain other practices that can present conflicts between the interests of brokers and their customers.” Some brokers are responding to critics of payment for order flow by offering rebates to clients. 

A few brokerages, for example, do not prearrange to generate payments for order flow. Instead, when they receive an order, it is routed to the best execution point. If the best price happens to be with a market maker that does pay for orders, the brokerage passes the payment to its customers in the form of monthly rebates. The practice of paying for order flow is providing ammunition for firms that allow customers to bypass the traditional role of the broker. So-called direct-access firms are attacking Web-based brokers head-on by offering technology that takes orders directly to the marketplace, rather than through a broker. 

With direct-access firms, investors execute orders directly with market makers, exchanges, or ECNs—wherever the best price exists. Cybertrader, Edgetrade, and E*Trade Professional are the latest to offer the individual investor direct access to the stock market by eliminating the role of the broker. Direct-access firms are appealing in that they offer the individual investor a higher probability of better execution. These firms cater primarily to active traders, however. Often, their commissions are based on the number of trades executed monthly, with more frequent traders getting cheaper commissions and access to services like research and quotes. Bottom line: If you are an active trader, direct access can greatly increase the efficiency and effectiveness of your orders.

INVESTOR SAFEGUARDS

When investing in the stock market, your fiduciary—the financial agent you trust with your money—is your broker. The SEC and the exchanges are diligent in their regulation of both brokers and their firms, but you still need to be aware of some of the possible indiscretions to protect against fiduciary fraud. First we will delineate these improper deeds and then provide the reader with six ways to self-protect one’s account. Some of the most common improprieties include:

Embezzlement. Usually a matter of a salesperson misappropriating your assets without the firm’s knowledge.
Misuse of assets. Using customer equity or cash to cover operating expenses, or as collateral for the firm.
Kickbacks. When order takers take bribes to direct trades to certain market makers, you end up paying for the bribe through higher customer prices.
Misuse of discretionary authority. Trading without customer approval, or without the best interests of the client in mind.
Churning. Increasing commissions by recommending excessive trading.
Front running. Trading for the firm or selected clients with advance knowledge of forthcoming research recommendations.
Conflict of interest. Arising from the brokerage firm’s role as market maker, underwriter, mutual fund manager, or investment adviser.

There a number of things you can do to protect your account. Use the following six guidelines to safeguard your stock market profits:

1. Do your own research before you invest. Don’t invest in companies that minimize or avoid disclosure of their financial condition. Always read the fine print in your information sources, and avoid hot tips.
2. Deal with major brokerage firms and reputable brokers. Know your brokerage firm’s financial condition and who owns the firm. Be sure you know exactly what your agreement specifies.
3. Keep a written record of all trades. Write your orders in advance. When you receive trading confirmations, be sure to compare them with your written records.
4. Put your broker to work. If trading confirmations are slow in coming, complain to your broker. Balance all monthly statements. Ask your broker to explain any discrepancies. If trouble persists, go to a supervisor. If it continues, change firms.
5. Change brokers who talk about sure winners. Resist all sales manipulation emphasizing double-digit rates of return, stocks that will double, hot stocks, and guaranteed profits.
6. Never put greed before safety. Sometimes you have to protect yourself against yourself, and that can be the most difficult job of all. Remember the stock market will be here tomorrow—but to use it, you need investment capital.

Hopefully this information will help you avoid or deal effectively with any account issues that you might experience. Investors who know how to choose a good broker, how to analyze information, how to order skillfully, and how to protect themselves are investors who know how to make money.

OPENING AN ACCOUNT

The first step on the road to being a trader is opening an account with a broker. This can be done using an online broker, over the telephone, or visiting a brokerage in your area. Today, I find that most traders prefer the online route. In any event, whether you use a broker on- or off-line, you start by signing a new account agreement. This somewhat legal-looking document may have you wondering if you are setting up an account or applying for a job. Nevertheless, the new account agreement is important for two reasons:

1. The new account form enables the brokerage firm to find out about you and your financial resources, including your assets, liabilities, income, net worth, and the like.

2. It spells out the terms and conditions that the broker imposes on you.

Therefore, while not particularly interesting, the new account agreement is your first look at the broker and, because it stipulates the terms of your relationship with that firm, is worth reading in detail.

As soon as the account form is reviewed and approved by the brokerage firm, you can begin trading. Based on your experience level and financial profile, the broker may impose limits on your trading (e.g., limit the use of credit, limit specific option strategies, or prohibit the purchase of certain speculative investments). In most cases, however, that will not pose a problem.

While the actual process of setting up a brokerage account is relatively easy, in the long run finding the right broker who meets your specific investment goals can be quite difficult. After all, there are a large number of online brokers out there these days. Determining which one is right for you can be a long and arduous process.

One of the most important considerations when evaluating various brokers is: What type of brokerage firm is it? In turn, in order to understand the differences between brokers, it is important to understand how they make money. Specifically, most of a brokerage firm’s revenues come from the trading activity of its clients. In other words, each time an investor buys or sells an investment security, the broker makes money through commissions.

Today, due to the sheer number of firms in existence, commissions (and/or sometimes fees) vary wildly. Furthermore, with the recent growth in online trading and subsequent competition, commissions have reached historical lows. Some firms even let certain wealthy clients trade for free. Others, however, provide specific investment advice and, therefore, require that investors pay higher fees and commissions for doing business with them.

As a generalization, commissions will be higher for brokers who offer specific advice to the investor. So-called full-service firms have financial consultants or financial advisers who not only buy and sell shares on your behalf, but also gather information about your financial resources and make specific recommendations. Other firms, sometimes called discount brokers, do not offer any sort of financial advice. They simply execute buy and sell orders on your behalf at the lowest cost possible.

For instance, to buy 100 shares of a stock trading for $55, a full-service broker will charge between $75 and $200, while a discount broker charges only $10 to $20. At the same time, a full-service broker will place the order in context of your personal financial situation and, if you request, offer advice as to whether it is a suitable investment for you. A discount broker will simply complete the transaction according to your instructions.

Charles Schwab and E*Trade are examples of discount brokers. If you are reading this book, chances are you will be a self-directed investor and it will not make much sense to use a high-priced broker. Instead, you will focus on online firms that specialize in options trading and have relatively low commission schedules.

THE OPTIONS ACCOUNT

Believe it or not, one problem new traders sometimes face is not being able to obtain permission to trade options from a broker. Clients of brokerage firms who want to trade options are required to complete an options approval form when opening new accounts. The options approval form is designed to provide the brokerage firm with information about the customer’s experience, knowledge, and financial resources. According to the “know your customer” rule, options trading firms must ensure that clients are not taking inappropriate risks. Therefore, the new account form and the options approval document gather appropriate background information about each customer. 

Once the documents are submitted, the compliance officers within the brokerage firm determine which specific strategies are appropriate for the client. The process is designed to ensure that inexperienced traders do not take inappropriate risks. For example, if the option approval form reveals that the client has little or no options trading experience, and then the client goes on to lose large sums of money via complex high-risk trades, the brokerage firm could potentially face regulatory and legal troubles for not knowing its customer. So, each brokerage firm is required to understand the client’s experience level and financial background to ensure that the customer is not trading outside of certain parameters of suitability. 

An individual’s past options trading experience and financial resources will allow him or her to trade within certain strategy levels. For instance, level 1 strategies include relatively straightforward approaches like covered calls and protective puts. More complicated trades, however, require a higher level of approval. Shows a typical breakdown a brokerage firm might use to group strategies by levels. Traders with a great deal of experience and significant financial resources can generally receive approval for level 5 trading. This would allow them to implement any type of trading strategy, including high-risk trades like naked calls and uncovered straddles. 

Although the options approval levels can vary from one broker to the next, level 3 is enough for most readers following the strategies. Since we do not recommend uncovered selling of options, approval beyond level 3 is unnecessary. At that point, traders can use a variety of simple strategies like straight calls and puts, as well as more complex trades such as spreads, straddles, and collars. In order to avoid the frustration of opening an account with a firm that will not allow trading in more advanced levels, new traders will want to find out the brokerage firm’s policy regarding options approval before funding an account. 

The best way to do this is to contact the firm’s options approval department by phone. If you have little or no experience, ask them what steps you need to take in order to trade the more complex options strategies (level 3). It sometimes helps to specify which trades (i.e., spreads, straddles, collars, etc.) you intend to trade. Often, the firm will ask you to write a letter or somehow demonstrate that you understand the risks of trading options. After that, most firms will allow you to fund the account and to begin implementing those options trading strategies that interest you.

TABLE  Typical Brokerage Firm Breakdown



ROLES AND RESPONSIBILITIES OF ALL BROKERS

Regardless of whether the broker charges high or low commissions, all brokers are regulated by the Securities and Exchange Commission (SEC) and are required to meet certain standards when dealing with customers. Specifically, the Securities Exchange Act of 1934 puts forth certain provisions that all brokers must adhere to.

Duty of fair dealing. This includes the duty to execute orders promptly, disclosing material information (information that a broker’s client would consider relevant as an investor), and charge prices that are in line with those of competitors.
Duty of best execution. The broker has a responsibility to complete customer orders at the most favorable market prices possible.
Customer confirmation rule. The broker must provide the investor with certain information at or before the execution of the order (i.e., date, time, price, number of shares, commission, and other information).
Disclosure of credit terms. At the time an account is opened, a broker must provide the customer with the credit terms and, in addition, provide credit customers with account statements quarterly.
Restriction of short sales. This rule bars an investor from selling an exchange-listed security that they do not own (in other words, sell a stock short) unless the sale is above the price of the last trade.
Trading during offerings. Rule 101 prohibits the broker from buying a stock that is being offered during the “quiet period”—one to five days before and up to the offering.
Restrictions on insider trading. Brokers have to establish written policies and procedures to ensure that employees do not misuse material nonpublic (or inside) information.

WHY PAY HIGH COMMISSIONS?

In a world of low-cost (in some cases, no-cost) trading and strict government regulation of brokers, does it ever make sense to pay the high commissions of a full-service broker? Sometimes it does. While investors are protected to an extent by federal securities laws, they are not protected from poor investment decisions. Investors often lose money in the stock market. There are risks and, in a world of do-it-yourself investing, the investor is ultimately responsible for ensuring that investment decisions are wise. The ultimate goal in investing is to preserve capital and improve your financial well-being. 

Investors are sometimes uncertain about the risks associated with an investment. If you are reading this book, you are probably not one of them. But, at times, a full-service firm can be helpful. For instance, firms like Merrill Lynch, Morgan Stanley Dean Witter, and Prudential have financial advisers or consultants who offer investment advice for a commission or fee. Sometimes paying a higher commission in exchange for objective financial advice is sensible. The important element in the equation, of course, is being confident that the information is objective and worthwhile. To find out, you can ask the perspective financial consultant a number of questions. 

The SEC has compiled a list of helpful questions to ask which can be accessed. Sometimes it makes sense to do both—that is, open an account with a brokerage firm to handle some of your retirement savings, money you have saved for an education, or other aspects of your portfolio, and then take a smaller percentage to trade options in a self-directed online account. For example, you might split your portfolio into 75 percent conservative investments and 25 percent with more aggressive options trades like long-term bull call spreads.

CONCLUSION

If you are motivated to the point that you want to invest in stocks, finding a broker and opening an account are relatively straightforward tasks. Over the long run, however, finding a broker to meet your particular investment needs can prove complicated. If you plan on doing one or two trades and are not seeking help with respect to your overall financial plan, a discount broker who simply executes your orders is appropriate. However, if you are not sure about whether the investment is a wise one, a fullservice broker, while charging higher commissions, may offer you objective and worthwhile information. Therefore, the first step in selecting a broker is determining the level of financial advice you need, if any.

Regardless of whether you trade one or a hundred times a month, brokers have a duty to execute orders promptly and at the best possible price. While it is difficult to monitor the brokerage firm from the time your order is submitted until the time it is executed, there are some things you can do. If you trade actively, monitor the market in real time and watch your trade take place. In addition, consider submitting limit orders (priced between the bid and the offer). Finally, if you have a bad trade—or in Street parlance, a bad fill—contact your broker’s customer service department and find out what happened. If the problem persists, remind them of their “duty of best execution.” If that doesn’t work, change brokers.

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