Subject: Trading - Discount Brokers

Last-Revised: 13 Mar 2005
Contributed-By: Many net.people; compiled by Chris Lott (contact me)

A discount broker offers an execution service for a wide variety of trades. In other words, you tell them to buy, sell, short, or whatever, they do exactly what you requested, and nothing more. Their service is primarily a way to save money for people who are looking out for themselves and who do not require or desire any advice or hand-holding about their forays into the markets. This article focuses on brokers who accept orders for stock, stock option, and/or futures trades.

Discount brokering is a highly competitive business. As a result, many of the discount brokers provide virtually all the services of a full-service broker with the exception of giving you unsolicited advice on what or when to buy or sell. Then again, some do provide monthly newsletters with recommendations. Virtually all will execute stock and option trades, including stop or limit orders and odd lots, on the NYSE, AMEX, or NASDAQ. Most can trade bonds and U.S. treasuries. Most will not trade futures; talk to a futures broker. Most have margin accounts available. Most will provide automatic sweep of (non-margin) cash into a money market account, often with check- writing capability. All can hold your stock in "street-name", but many can take and deliver stock certificates physically, sometimes for a fee. Some trade precious metals and can even deliver them!

Many brokers will let you buy "no-load" mutual funds for a low (e.g. 0.5%) commission. Increasingly, many even offer free mutual fund purchases through arrangements with specific funds to pay the commission for you; ask for their fund list. Many will provide free 1-page Standard & Poor's Stock reports on stocks you request and 5-10 page full research reports for $5-$8, often by fax. Some provide touch-tone telephone stock quotes 24 hours / day. Some can allow you to make trades this way. Many provide computer quotes and trading; others say "it's coming".

The firms can generally be divided into the following categories:

  1. "Full-Service Discount"
    Provides services almost indistinguishable from a full-service broker such as Merrill Lynch at about 1/2 the cost. These provide local branch offices for personal service, newsletters, a personal account representative, and gobs and gobs of literature.
  2. "Discount"
    Same as "Full-Service," but usually don't have local branch offices and as much literature or research departments. Commissions are about 1/3 the price of a full-service broker.
  3. "Deep Discount"
    Executes stock and option trades only; other services are minimal. Often these charge a flat fee (e.g. $25.00) for any trade of any size.
  4. Computer or Electronic
    Same as "Deep Discount", but designed mainly for computer users (either dial-up or via the internet). Note that some brokers offer an online trading option that is cheaper than talking to a broker.

Here are some examples of firms in various categories:

Full-Svc. DiscountDiscountDeep DiscountComputer
Fidelity Ameritrade Brown E*Trade
Charles Schwab TD WaterhouseScottrade
The rest often fall somewhere between "Discount" and "Deep Discount" and include many firms that cater to experienced high-volume traders with high demands on quality of service. Those are harder to categorize.

All brokerages, their clearing agents, and any holding companies they have which can be holding your assets in "street-name" had better be insured with the S.I.P.C. You're going to be paying an SEC "tax" (e.g. about $3.00) on any trade you make anywhere, so make sure you're getting the benefit; if a broker goes bankrupt it's the only thing that prevents a total loss. Investigate thoroughly!

In general, you need to ask carefully about all the services above that you may want, and find out what fees are associated with them (if any). Ask about fees to transfer assets out of your account, inactive account fees, minimums for interest on non-margin cash balances, annual IRA custodial fees, per-transaction charges, and their margin interest rate if applicable. Some will credit your account for the broker call rate on cash balances which can be applied toward commission costs.

You may have seen that price competition has driven the cost of a trade below $10 at many web brokers. How can they charge so little? Discounters that charge deeply discounted commissions either make markets, sell their order flow, or both. These sources of revenue enable the cheap commission rates as they profit handsomely from trading with your order or selling it to another. Market making is the answer.

In contrast, Datek is one of a kind. Datek owns the Island, an electronic system that functions as a limit order book that gives great order visibility and crosses orders within it as well as showing them to the Nasdaq via Level II. Datek charges a fee from Island subscribers to enter orders into their system. Island is their outside revenue, and is far superior to selling order flow. Island is good for the customer, selling order flow like the others is not.

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