What You Need to Know About Choosing a Broker
Aside from charting tools and market research, there are two important but often overlooked decisions for a trader to make; choosing a brokerage firm and a specific broker. Each of these decisions is capable in having a profound impact in your overall trading results and you owe it to yourself to take the time to make an educated judgment.
Choosing a brokerage firm
Deciding on a brokerage firm is a significant decision and shouldn’t be taken lightly. Before committing to a firm it is imperative that you research their services, experience, trading platforms and commission structure but more importantly whether your trading style and personality will be compatible. For example, a beginning trader shouldn’t look to a deep discount online brokerage firm simply because they likely won’t get the guidance that they will need as a novice. Similarly, a seasoned trader wouldn’t want to choose a firm that focuses on high-end service with a hefty price tag.
IB or FCM?
There are many misconceptions as to what the difference is between an IB (Introducing Broker) and an FCM (Futures Commission Merchant) and how those differences will influence the clients trading practices. We would like to take this time to set the record straight.
According to the Chicago Mercantile Exchange, and FCM is defined as an individual, association, partnership, corporation or trust that solicits or accepts orders for the execution of a commodity transaction on the pursuant to the rules of a futures contract market and which accept payment from or extend credit to customers.
An IB is essentially a “mini” brokerage firm that is in business for the sole purpose of soliciting accounts for an FCM. In other words, an IB brings clients to an FCM and the FCM executes trades. An IB doesn’t accept the client’s money in its own name; instead all of the client’s monies are written directly to the FCM and deposited into a customer segregated fund held by the bank of the FCM. For the most part, an IB relies on the FCM to handle operations such as customer service and technical support. Although, a quality IB will be able to assist you in many of the day-to-day activities so you should always refer to your broker first and FCM second.
All customer statements and end of year tax reporting (1099’s) are issued directly from the FCM. Without understanding what an IB and FCM are, it can be confusing to look at a brokerage statement for a client that is trading with an IB. The brokerage statement will have the name, and most likely the logo, of the FCM but will identify the IB in small text usually subsequent to the text “Business Introduced By”.
Understandably, people assume that they have an account with the FCM when in reality they have an account with an IB that clears trades through that particular FCM. Once again, any issues or questions should be addressed with your broker, the IB, first. Only after you are unsatisfied with your broker’s response or resolution should you escalate your concerns to the FCM.
Additionally, your broker may choose to change FCM’s in which trades are cleared at any time. Unless you specifically object, your account will stay with your broker and begin clearing trades through the new FCM; insiders refer to this as a “bulk transfer”. In other words, you are the client of the IB’s not the FCM unless of course you would like to change brokers.
You may often hear of brokers that are working directly for FCM’s insinuate and that because they are clearing members of the exchange they can provide clients with more efficient fills. Perhaps several years ago this was in some views accurate. However, as online trade execution has become predominant this statement is no longer valid. If you place an order to buy a mini-sized Dow at the market through an IB and through an FCM simultaneously there will likely be very little if any difference in the fill. In fact, if there is a difference it is likely due to your inability to trigger the execution simultaneously.
Another myth regarding IB’s is that they aren’t capable of offering competitive commission rates. An IB is essentially a “middle man” to the client and the FCM. On the surface, the relatively higher commission charged by an IB seems to be logical. After all, there is an extra hand in the cookie jar. First the FCM must be paid for executing and clearing the trade, then the IB must be paid for services rendered. However, a further look into the details reveals that IB’s may have the ability to offer lower transaction costs than many FCM’s.
Many FCM’s allow full service brokers to set their own commission schedules within pre-approved boundaries and the fact that the commission payout to a broker working for an FCM is often far less than that of a broker that is either an IB or working for an IB. In theory, the increased exposure and name recognition of being employed by an FCM will far outweigh the difference in payout but that is an argument that is well beyond the scope of this article and likely your interest. In reality, brokers that receive a higher percentage of the commission charged are able to “afford” to offer lower rates to customers. Thus, you may find that many IB’s are very competitive in terms of transaction costs.
In my opinion, there are no benefits to trading with an IB over an FCM or vice versa. The true value is in finding a broker that meets your individual needs and will handled your account efficiently.
Discount or Full Service Specialization
There are firms that offer a blended array of services and others that specialize in either full service or online discount. Being honest with yourself regarding your skill level, market knowledge, your needs and your trading style is a must for choosing the type of brokerage firm. If you don’t know yourself, how could you possibly be able to choose what services are best for you?
Once you have determined what it is that you are looking for, there are a few things that you should keep in mind. Based on my observations, it seems likely that as you move down the commission scale (from high rates to low rates) the adage “you get what you pay for” becomes more and more appropriate. In other words, don’t expect unrealistic service or trading results simply because you are with a firm that is charging $100 per round turn. On the other hand, if you are paying 99 cents per side you will likely get what you pay for which is very little service. That may not be a bad thing if you are an experienced trader with adequate knowledge of the trading platform that you are using to execute trades and have reliable technology at your fingertips. If you don’t fit into this category, I strongly suggest that you seek services that may be a little more expensive in terms of commission but much cheaper in terms of trading mishaps.
Blanket Commission Structure or Variable
As a retail account, you must understand that while all brokerage firms want business, each client account opened poses a significant risk. This is because in futures and short option trading it is possible to lose more money than is deposited in the account. A negative account balance is psychologically devastating to a trader but is equally as stressful to a brokerage firm. The brokerage firm is expected to cover any negative balance with the exchange immediately and unbelievably your individual broker is expected to cover your negative account balance with his/her commissions prior to you bringing the account whole again. With this known, it is easy to see that any commission charged is partly attributable to the risk of a negative account that the firm is facing by taking you as a client. Accordingly, clients that are deemed to be a relatively higher risk to a broker or brokerage firm will likely be charged a higher commission accordingly. As with any other industry, risk and reward are highly correlated. Thus, although a brokerage firm’s primary business is executing trades they must also think like an insurance company.
Insurance companies collect your personal data and characteristics in order to accurately assess the risk of issuing a policy and determining a premium accordingly. Such a system ensures that each policy holder is paying for the coverage rendered, nothing more or nothing less. Without such categorization, blanket premiums would be levied causing those with low risks of a claim to subsidize those with high risks of a claim. For example, an avid smoker would be paying the same amount of money as an avid jogger for a health insurance policy with identical coverage. The smoker would be paying less than he should be relative to the potential risk to the insurer, while the jogger would be paying more than he should to compensate the insurer for coverage. This approach is clearly ineffective in rewarding positive behavior, consequently insurance firms use customer profiles to prevent such imbalances from occurring.
Brokerage firms may look to the same logic when determining commission schedules. While the determining characteristics aren’t quite as definable as they may be in regards to insurance, there are definite factors that should be considered in the amount of commission charged. One of those factors is account size. All else being equal, a trader with a large account poses less risk and is more valuable than a trader with a relatively small account. Therefore, in most circumstances a trader with a larger account deserves a lower commission rate than one with a smaller account.
Another component to determining commission should be trading style. This is often something that may be determined after the account has been open and trading. For instance, a trader that has a well-funded account and typically uses approximately half of the available margin on a given day is a relatively low risk client. On the other hand, a trader that is constantly pushing the limits in terms of margin poses a substantial amount of risk to a trading firm.
Trading Platforms
If you are a position trading using options or futures, trading platforms shouldn’t be a high priority. For position traders, simply having the means of easily placing trades and monitoring the account is sufficient. There is no need to complicate things unnecessarily.
On the contrary, if you are scalping, or any other form of day trading, the front-end platform that you will be using to enter trades becomes very important. Not only must the platform be quick as well as easy to use and understand, it can’t be so quick and easy that mistakes are highly probable. If you are a day-trader you are most likely following products that are executed electronically. If this is the case, most platforms are offered in live demo versions in which you can determine which is preferable to your needs.
Floor Presence
Insiders often refer to a clearing FCM as having “floor presence”. This means that they own a seat on the exchange and clear their own trades. In theory, because they are privy to the action they may be able to provide clients with better execution. However, the execution of electronic contracts will provide very similar results regardless of whether you are trading with a firm that is a member of an exchange. Whether a firm does or doesn’t have a floor presence only comes into play should the client be trading open outcry products.
For those that are trading open outcry options or option spreads I recommend using a full service broker that is experienced in this type of trading. A broker that handles a lot of option business will have contacts on the trading floor that will be happy to execute trades for a small fee, often referred to as a give up fee. Using a give up broker is preferable in many cases whether the firm has a floor presence or not. Thus, trading through give up brokers eliminates any benefit that a trading firm being a member of the exchange will bring. Simply put, your execution may rely on the individual broker handling your full service account than the brokerage firm he or she works for.
Customer Service
Clearly, a customer service department is there to make your life easier. They should be well informed of all back office issues and capable of meeting your needs in a timely manner. Unfortunately, it is very difficult to determine whether or not a customer service department is efficient until after your account has been open long enough to experience its capabilities. However, prior to opening an account you may want to browse the internet forums and message boards for ratings of the prospective brokerage. Keep in mind, that if you are looking to trade with an IB you should be looking for information on the customer service department of the FCM not the IB. Although, you will be primarily in contact with your IB and you should have a good idea of what type of service they are capable of offering.
Tech Support
With the growing popularity of online trading it is imperative that the firm that you choose have a well staffed and knowledgeable technical support staff. Without it, you may find yourself in a very frustrating situation. Imagine entering a market just before your trading platform “crashes”. It is true that you would be able to quickly call your broker to offset the trade, nonetheless you would want immediate resolution to your issue. It is difficult enough to make money in the markets, the last thing that you need is technical trouble and frustration over poor technical support.
You may want to go as far as to ask your prospective firm approximately how many people make up their tech support staff. The answer may be surprising. I have known relatively large firms to have two member technical support departments. Depending on the size of the firm, this may not be enough to service the needs of the firm and may result in long hold times.
Choosing a broker
Most traders that are in the market for a broker are concerned primarily with trading platforms, commission and the quality of information provided such as newsletters. However, if you are in the market for a full service broker, you need to take your research one step further. Not only do you need to find a firm that is capable of meeting your logistic needs, but also it is crucial that you choose an individual broker in which you can properly communicate, is comfortable with their experience and most of all trust to help you on your journey to being a successful trader.
Understand Your Broker
Despite the impression that you may have gotten from watching the movie “Trading Places” or reading industry publications, being a broker has few perquisites…unless you are good at what you do. The industry is commission based and has the potential to be lucrative for those who are willing to put forth the effort. When it comes to being a successful broker, effort is synonymous with an open mind and a constant yearning for information, a commitment to providing unparalleled service and networking with floor brokers to ensure efficient execution for their clients. The hours are long, but it is easy to see how one could fall in love with the excitement of it all.
For those who fail to put forth the effort necessary to make a decent living as a commodity broker, the pay is hardly worth the time. In fact, there is a high probability that a fast food chain or even unemployment benefits would pay more. In my experience, I estimate that about 80% of the brokers in the commodity industry fall into this category. The other 20% make a respectable living, hopefully through providing their clients with the service that they deserve at a reasonable price.
A big concern facing the industry is the fact that brokers are provided incentives in the form of commission. Those who are short-sighted and fail to employ a long term business plan are tempted to churn, or overtrade, accounts. Accordingly, they may encourage clients to trade in an attempt to increase their commission check without always holding regard to the best interest of the client.
Ironically, it seems as though many of the brokers who approach their clients aggressively in an attempt to generate commission fall into the 80% of brokers who struggle to survive. There are a few steps that you can take to evaluate whether your broker fits your needs as a trader and is qualified to earn your business.
The NFA Website (www.nfa.futures.org)
Once you have determined your candidate for a brokerage firm, you should visit www.NFA.Futures.org to access their BASIC (Background Affiliation Status Information Center) database. The database contains CFTC (Commodity Futures Trading Commission) registration and NFA membership information. The site will give you the ability to submit a query on your prospective brokerage firm and the individual broker. The information provided will include the length of your broker’s registration and a list of regulatory actions, NFA arbitration awards and CFTC reparation cases in which the broker has been involved. Keep in mind that a CFTC reparations claim doesn’t infer guilt; many of the claims may have been settled, dismissed or withdrawn. However, you may want to confront your broker in the matter. You may also find information on any NFA arbitrations which is a dispute resolution rather than a regulatory action and any regulatory actions. I am sure that you would agree that knowing whether your broker may have been party to questionable practices in the past can be important.
Get to Know your Future Broker
You probably wouldn’t choose a business partner in which you haven’t established the potential for efficient communication, have confidence in their ability to bring something positive to the relationship and most of all trust. Why would you think of choosing a broker without doing these things?
Becoming familiar with your broker before you ever begin trading is a significant step in the right direction. The vital areas of concern are their educational background, experience in the industry and, most important, general market knowledge. A college degree in finance isn’t necessarily a reason to open an account with someone and neither is the fact that he or she has been in the business for twenty years. However, considering these factors in conjunction with a well-rounded grasp of market characteristics and proper lines of communication are key. You should be able to determine whether a broker fits your needs and personality with a twenty to thirty minute conversation. During this time, don’t be shy. If they want to do business with you, they must be able to answer your questions assuming they are reasonable.
Work Ethic
In order for you to be a successful trader you must have access to your broker. If he is hard to get a hold of or slow to return your calls and emails, you should strongly consider shopping around for another broker. Many brokers feel as though once the markets close they are off duty and free to leave the office, however, doing so isn’t making themselves available for their clients. Those paying full service rates deserve better.
Work Experience
This may seem like none of your business but that is where you are wrong. Think about it, if you were interviewing someone for a position as a convenient store clerk, one of the first things that you would require is a list of prior employers. When you open an account with a broker you are in essence hiring them to provide you with service, knowledge and honesty. Arguably, this position requires more experience than a cashier and the interrogation should be at least as extensive. In my opinion it is absolutely necessary to know what type of skill the broker can offer you and this includes having an idea of their employment history.
Trading Background
Don’t be afraid to ask a prospective broker how long he or she has been involved in trading. A prospective broker’s experience in the markets may pre-date his or her days as a broker. Also, ask whether he or she is trading a proprietary account or for friends and family. If the answer is no, you shouldn’t be immediately turned off. In fact, trading a personal account is seen as a conflict in the industry. As a result, brokers often have to “take a back seat” in their trading. For example, preferable fill allocation always goes to the client while the broker receives the least favorable fill on a block ticket. While I agree with the concept, it leaves a broker slightly behind the curve. Additionally, I think that you will agree that you would rather have a broker that puts you and your account before his or hers. On the other hand, you wouldn’t want to put too much credence into a broker that has never had real money on the line.
Trading Execution
Perhaps one of the most important aspects of the service that your prospective broker can offer is execution. When it comes to electronically traded contracts such as the e-mini there is very little, if any, difference between firms assuming that the trading platform is reliable. However, when it comes to open outcry execution the difference in brokers can be tremendous. An experienced retail broker will have contacts directly on the trading floor that are capable of providing accurate bid/ask spreads as well as efficient and effective fills. Floor brokers charge what is called a “give up” fee, normally between $2 and $4 but the fill quality is worth far more. If you intend to do a significant amount of open outcry option business (spreads, or those contracts only traded in pits) I strongly recommend working with a broker that is capable of executing your order through a “give up” firm.
In Conclusion
Your ultimate experience may be determined in large part by the individual broker that is handling your account. Likewise, an experienced broker will be capable of delivering efficient execution and excellent service regardless of whether or not they are working for an IB or FCM. With that said, when picking a firm to execute your trades and handle your account, cutting corners isn’t an option. Although it isn’t’ as fulfilling, you should be researching brokerage firms and prospective brokers nearly as much as you research the markets. With that said, many commodity brokerage careers are cut short by the realities of the business. Make sure that your broker is in it for the long haul before investing too much time into the relationship.
*This article provides a glimpse into Carley Garner’s latest book, A Trader’s First Book on Commodities: An Introduction to The World’s Fastest Growing Market.
*There is substantial risk in trading options and futures.
Carley Garner is Senior Market Analyst and Broker with DeCarley Trading, and a columnist for Stocks and Commodities. The co-author of Commodity Options and author of the upcoming book, A Trader’s First Book on Commodities, Garner writes two widely-distributed e-newsletters, The Stock Index Report and The Bond Bulletin. She provides free trading education to investors at www.DeCarleyTrading.com. Garner is a Magna Cum Laude graduate of the University of Nevada Las Vegas.