Who Should You Trade Through
Stockscores.com Perspectives for the week ending November 26, 2004
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In this week's issue:
The stock market today is dramatically different than it was 20 years ago, and so are the options for trading it. Where the stock market was once a place reserved for the wealthy and influential, it is now accessible to anyone willing to open an account at a brokerage house. There are now a number of options available to individuals wishing to buy, sell or short sell a stock.
As a general term, a brokerage is an organization established to execute trades for their clients. There are really no other practical ways to access the stock markets if you want to trade a stock. The brokerage industry today is extremely competitive, and there are a lot of options for you to consider when selecting a brokerage. Because of the competitive landscape of the brokerage industry, we need to be cognizant of how the business works, and how services are priced. Here is an overview of the different kinds of brokerages available:
Traditional
Traditional brokerage houses provide a full scope of service to their clients. They not only facilitate trade orders, but their representatives (brokers) will provide advice on what to buy and sell. These brokerages have analyst departments that prepare research reports for their clients' consideration.
The advice comes with a price; full service traditional brokerages are typically the most expensive way to execute a trade. The advantage to investors is that they provide direction and manage the decision making process. However, there are no guarantees that they will be successful with the choices they make.
When you execute a trade through a full service broker, the order is typically written out on a trading slip by the broker, and given to the trading desk. The traders then work to fill that order, either from their own inventory of that stock or as an order routed through the market. Because there are a number of hands that touch the order, the process can be somewhat slow.
Discount
Discount brokerages became popular in the mid-eighties, when investors who wanted to make their own decisions began looking for lower commission trades. Since these individuals were making their own buy and sell decisions, they did not want to pay a traditional brokerage the fees that came with the services they offered.
Today, discount brokers have the largest number of clients, and have a few different ways of making money. Most people believe that the discount broker only makes their money from the commission charged for the trade. However, the discount brokerage also has an opportunity to profit from the order flow, because they have traders and market makers who attempt to skim a small profit from the trade by executing at a better price than the client is aware of.
Here is how this works. Suppose you want to buy a stock that you see trading at $10. You enter an order to buy 1000 shares at $10 through the discount broker's order entry system (usually a website or over the phone). That order is then routed to the trading desk, where the discount broker's traders work to fill your order. They will try to buy that stock for something less than $10, so they can sell it to you at your set price of $10.
It is quite possible that the trader can get the stock for $9.97, meaning that there is a $0.03 per share profit for the trader, who then sells the stock to you at $10. While you think you are only paying the commission on the trade (this might be anywhere from $5 - $35 per trade through most discount brokers), you are unknowingly paying another $30 for the better share price the trader was able to get.
This will not happen on all trades routed through a discount broker, but it is a possibility on every trade. The process can increase the cost of the transaction to you, although you will not know the difference. It can also increase the amount of time that it takes to execute the order.
Discount brokerages will not usually offer any advice to you on what to trade, although some do provide research tools and services that you can utilize when making your own decision. Because discount brokerages are often very large, they may have convenient offices close to you.
Direct Access
Direct access brokerages are a newer variety of discount brokerages that also charge a very low commission, but they bypass the market maker system and route your order directly to the stock markets.
Unlike discount brokers, the direct access broker does not try to skim some profit from your order by executing the order through their proprietary trading desk or their market makers. Instead, your order is routed directly to the stock market, and no one skims a profit from your trade. You can get the stock trade filled at the best possible price.
This means that the time to fill your order is about as quick as it can be. There are no middle men slowing the process down, making it possible to have your order filled within a couple of seconds.
Since direct access brokers offer very low commissions, you should not expect a lot of extra service. The direct access broker will provide a trading platform to execute your trades using your computer, and usually have a help desk that you can call when you have a question or issue. Most direct access brokers are smaller companies, so they are not likely to have an office in every major city. Instead, you will have to transfer your money to them electronically or by mail.
Which One is Right for You?
Few people reading this book will have a use for a traditional brokerage, since the reason you are taking this course is to make your own investment decisions. Rather than pay someone else to do this for you, you should be considering the much lower commission structures that come with a discount or direct access brokers.
Discount brokers tend to be more expensive than direct access brokers. While the commission rate advertised may seem lower, the order can be more costly when you factor in the way the order is routed by the discount broker.
You do get something for the extra costs you incur with a discount broker. They may offer more tools and information to you for evaluating the stocks you are considering.
Ultimately, I believe that direct access brokers are the best choice for most people seeking to trade. The true cost to execute an order is lowest with this group, and the time it takes to execute your trades is very fast. For traders making their own decisions, and trading actively, direct access is the obvious choice.
You should be aware of hybrid direct access brokers. These are firms who use both order execution models; one that is true direct access, and another that is routed through their trading desk with the intention of profiting from the order flow.
Often, hybrid firms will advertise very low commission rates because they intend to try and skim some profit from your trade by getting a better price in the market than you are willing to execute at. Since these companies call themselves direct access brokers (because they also offer this service), the customer is often not aware of how their order is really being routed, and what the implicit costs of the transaction are. The cost to you can be greater than the obvious commission.
Therefore, I recommend that you use a true direct access broker, and make sure that your order is being routed as direct access and not through a trading desk. As a simple rule, you should be able to choose your order route (through Archipelago, Island, MBTX etc.) when you are trading direct access. If you don't have the choice, you are probably not trading direct access. I will explain direct access order routing in the Trade Execution chapter of this book.
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Stocks go up in price because investors are willing to pay more. Investors tend to buy companies that they are optimistic about, so it is important to measure whether investors are generally optimistic or pessimistic about a company. Stock charts can provide many clues about the mood of the market. For example, rising bottoms on a stock chart indicate greater enthusiasm among buyers than sellers.
The Sentiment Stockscore considers these kinds of chart pattern factors, and provides an indication of whether investors are showing optimism or pessimism. I have found that stocks that have a Sentiment Stockscore moving through 60 and rising tend to continue to rise as investor optimism carries them along.
The Sentiment Crossover Market Scan seeks stocks that have their Sentiment Stockscore crossing in to the 60 and greater zone after a lengthy period below 60. If this occurs, and the stock does not have significant overhead resistance, then there is a good potential for a future uptrend. By limiting downside potential with a stop loss point just below a short term support price, investors can better manage risk while leaving the potential for price gains.
This strategy is good for identifying longer term trades that do not require constant monitoring. The criteria are relatively simple, and a regular check of positions for an exit signal may only take a few minutes.
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1. PTEN
PTEN is tickling its way through resistance at $20 and if it can make a solid break through the resistance level, has good potential to move up toward the top of the July downward gap at $32.50. I would like to see a breakout on good volume support.
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2. CPTH
CPTH made a try at a breakout through resistance from an optimistic rising bottom pattern. The stock failed to hold the gain on Friday, but I think it is worth watching closely as it appears that investors are taking an interest in the stock. Watch it for a sustained break through resistance.
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References
Get the Stockscore on any of over 20,000 North American stocks.
Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
Scan the market using extensive filter criteria.
Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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