Brokers and Online Trading Tutorial - Open Computing Facility

Updated 04/29/2006

Brokers and Online Trading Tutorial

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Table of Contents

1) Brokers and Online Trading: Introduction 2) Brokers and Online Trading: What Does A Broker Do? 3) Brokers and Online Trading: The Costs 4) Brokers and Online Trading: Full Service Or Discount? 5) Brokers and Online Trading: Choosing A Broker 6) Brokers and Online Trading: Accounts and Orders 7) Brokers and Online Trading: Conclusion

Introduction

Brokers share the undesirable reputation of lawyers, bankers and accountants. They earn a living by selectively sharing knowledge that the general public can't easily access. But, like it or not, they are the individual investor's direct link to Wall Street. Although technology and the internet have made it easier for individual investors to take control of their portfolios, the basic rule still applies: you need some kind of broker if you want to trade stocks and bonds.

In any profession, you will find people who take advantage of those who aren't in the know. Whenever you buy something, there is the possibility of being cheated. Furthermore, with a broker you purchase advice, which is hard to price. But not all brokers fit the swindler stereotype. In fact, there are many brokers who do a phenomenal job of guarding their clients' interests. There are also many discount brokerages that provide remarkable services for a reasonable price.

It's up to you to pick the broker that meets your needs. This tutorial will go over some important factors to consider when making the choice.

If you are new to the market and don't have a solid understanding of the various securities, check out the Stock Basics, Bond Basics and Mutual Funds tutorials.

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What Does A Broker Do?

Brokers are the people who handle customer orders to buy and sell securities. In the same way that a grocery store acts as a middleman between shoppers and the companies that produce food, a broker acts as a middleman between the securities that trade on the market and the investors who buy them.

We should also mention that the word "broker" can be used in a variety of circumstances. It could mean an individual person you deal with or it can refer to a brokerage firm such as Charles Schwab or Merrill Lynch.

To be a stockbroker in the United States, you must pass two licensing examinations from the National Association of Securities Dealers (NASD): the Series 7 and the Series 63. These exams prove that a broker is informed about what he or she is selling and knows all the regulations and laws in the securities industry. Most countries have similar licensing programs.

The most important thing to realize is that brokers are salespeople. They get a commission when you trade. This will be our focus in the next section.

The Costs

Opening an Account Every brokerage has different terms and conditions for opening an account. There is a wide range of minimum deposits, varying anywhere from $500 to $2,500. Make sure you read the fine print beforehand. There is nothing more irritating than spending the time to fill out application forms only to discover you don't have enough money to open an account.

So, you're not loaded? Don't worry, more and more online brokerages don't require a minimum deposit at all.

Another option for those with small bank accounts is a dividend reinvestment plan (DRIP). A DRIP allows you to circumvent brokers by buying stocks directly from the companies that offer them.

Commissions and Fees Every brokerage charges a different price (called the commission) to trade. The price is usually indicative of the service, so cheaper isn't always better.

? The dirt-cheap brokers who charge $5 to $15 per trade get the job done.

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Prices are going down all the time and quality is getting better, but don't expect great support or perks. ? The mid-priced discount brokers typically charge anywhere from $15 to $30 per trade. These brokers generally offer better customer support and additional services. ? Expensive brokers come with high costs. In some cases you can expect to spend upwards of $100 to $200 per trade. These brokers are known as full-service and we'll discuss them in greater detail in the next section.

The prices above are a very rough guide. Commissions on trades vary based on things like the type of trade (e.g. market order versus limit order). Even the method used to do the trade affects the price; commissions are different for online orders, touch-tone phone trades and broker-assisted trades.

The Hidden Fees In general, the financial industry is excellent at hiding fees and charges under a layer of jargon. Beyond the commissions per trade, look for the following:

? Fees for transferring assets both into and out of an account ? Account maintenance fees ? Inactivity fees ? Fees for not maintaining a minimum balance ? Interest on margin loans ? Sales charges on certain securities (e.g. loads on mutual funds)

Make sure you shop around, but bear in mind that many of these fees are standard across the board.

Full Service Or Discount?

What really sets brokers apart is whether they are full service or discount brokerages.

Full-Service Broker The full-service category includes all the names that spring to mind when we think of brokers: Merrill Lynch, Salomon Smith Barney, Morgan Stanley Dean Witter and others. They provide a variety of services, such as personal advice, retirement planning and tax tips. Full-service brokers offer a wider selection of investment products such as derivatives and insurance, as well as access to the company's research. All this comes with a hefty price tag. Full-service brokerages are expensive, with commissions around $150. Furthermore, fullservice brokers are compensated based on how much you trade, not the

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performance of your portfolio. This can lead to your full-service broker advising you to trade when you don't need to. When this becomes excessive, it is called churning.

Discount Brokers Discount brokerages charge a reduced commission and do not provide investment advice. The best-known discount brokers are Charles Schwab and TD Waterhouse. Fees are kept low because discount brokers offer fewer products. Brokers are paid on salary and not on commission. The business model is built on having an effective system and quality service in order to put through the most volume.

Online Brokers and a Blurring Industry A few years back, some spoke of a third category of brokerage - those with online trading systems. Today, hardly a discount broker exists that doesn't offer online trading. Trading over the internet has definitely benefited the self-directed investor. Commissions have been reduced and individuals exert greater control over their accounts. Online trading has affected the industry by blurring the line between full-service and discount brokers. As discount brokers become increasingly common, they are providing access to high-quality research, while the old-school full-service brokers now offer online trading options as well.

Choosing A Broker

What's Your Style? Deciding whether you need full-service or discount is your first step. The choice is up to you, but taking charge of your own portfolio can be a very rewarding and profitable experience.

On the other hand, full-service brokers also have their time and place. Although you'll pay more, losing money on commissions is better than wiping out your portfolio because you don't understand the market. The bottom line is that the type of broker you choose should be based on your individual needs.

Check the Background The next step is to check the background of the firm and/or broker for any past disciplinary problems.

Securities regulators have made this information relatively accessible through the Central Registration Depository (CRD), a disciplinary and employment database available from NASD Regulation. You can perform online searches on the NASDR website for certain information and request that a detailed report be sent to you.

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You can also ask your state securities regulator to provide you with information from the CRD. The North American Securities Administrators Association website has info on how to get in touch with state regulators.

We apologize to visitors from outside the United States. This information is U.S. specific. We suggest you contact regulators in your home country for information on how to check the background of brokers.

Accounts And Orders

Types of Accounts Depending on what type of securities you hold, there are four major choices you have when opening an account:

Cash Account: The basic account where you deposit cash to buy stocks, bonds, mutual funds, etc.

IRA Account: For people looking to set up an individual retirement account.

Margin Account: Margin basically allows you to borrow from your broker against the cash and securities in your account. Profits can diminish quickly when you use margin, so be very careful! Learn about how this works in our Margin Trading Tutorial.

Option Account: Only seasoned investors should consider this choice. This type of account allows you to trade options, which are much riskier investments than stocks or bonds.

If you already have a brokerage account and wish to move it to another broker the process is quite easy. Just contact the brokerage you are signing up with and they will either do the paperwork for you or help you with the proper forms.

I'm ready to trade, now what? In order to make your trade you have to be specific about how you want the transaction to be performed. The following are common order types you'll encounter when placing an equity order using an online interface or the phone:

Market Order: An order that requires immediate execution at the best price available. These are generally the cheapest trades to place because there is little work or maintenance required by the broker.

Limit Order: An order to transact at a specified price. This guarantees the price at

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