ndthat next big winner? Some web sites, such as the Platinum site at Op-tionetics.com,  now  offer  investors  a  way  of  screening  for  stocksbased  on  a  number  of  variables  (P/E  ratios,  price-to-book,  marketvalue, etc.) in a matter of seconds.
Many  brokers  and  other  ﬁnancial  services  ﬁrms  are  recognizing  thechanging needs of online investors. In response, some of Wall Street’s bignames are using a combination of both online and full-service amenities towoo investors. Others are hoping to attract new accounts by offering ﬁnan-cial planning as well as an amazing array of portfolio building services. Theongoing evolution in web-based ﬁnancial services continues and serves asfurther 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 optionsor  futures  transactions.  Most  brokerage  ﬁrms  provide  either  stocks  andoptions  or  futures,  not  both,  because  futures  are  regulated  separatelyfrom stocks and options. Some ﬁrms, like Cybertrader, allow you to tradeboth, but you must maintain two separate accounts in order to do so. Ineither case, your chief concern as a trader should be to get the transactionexecuted as you desire and at the best price possible. Choosing the rightbroker  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 shouldbe an asset to you, should have sufﬁcient knowledge of the markets youtrade and invest in, and be able to make ﬁrst-rate suggestions to helpyou  increase  your  proﬁtability.  As  a  novice  investor,  be  very  carefulwith  your  broker  selection.  Look  for  a  broker  who  has  knowledgeabout  a  wide  variety  of  option  markets,  including  margins,  spreadstrategies, volatility, points, strikes, and so on. Interview potential bro-kers by presenting a speciﬁc trade to see if she or he can talk intelli-gently  about  it.  Can  she  or  he  deﬁne  the  market  conditions,  risk,potential return, breakevens, and so on? Ask the broker how much of a
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percentage  of  their  revenue  comes  from  options.  Look  for  a  brokerwith a similar risk proﬁle as yours. Most importantly, make sure yourpersonality ﬁts the broker’s personality—you really have to be comfort-able  with  their  style  and  time  availability.  You  should  also  ﬁnd  out  ifyour broker’s backup assistants understand options as well. Inevitably,you will end up dealing with assistants, and they need to be knowledge-able about options or you will ﬁnd frustration down the road.
2. Invest  your  own  account. Information  from  your  broker  should  beviewed as a potential opportunity, not as advice. Once again, ask yourbroker for suggestions, not advice. It is very important that you alwaystake responsibility for your own proﬁtability.
3. Do  your  own  homework. Study,  study,  study.  Continue  to  do  yourhomework even after you’ve achieved success, because the learningprocess never ends when you’re in the investment ﬁeld. The day youthink you have learned it all is the day you should retire. Overconﬁ-dence 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, lis-ten  to  what  your  broker  has  to  say,  but  never  make  an  investmentwhile still on the phone. End the call and put the phone down. Thinkabout the information you have received and then do an analysis ofrisk  and  reward.  If  you  still  ﬁnd  the  suggestion  to  be  valuable,  thencall back and make the investment. My biggest mistakes were hastyinvestment decisions.
WHAT MAKES A GOOD BROKER?
Much advice has been given as to just what makes a good broker, and justwhat one must look for in opening a brokerage account. The key elementsof most advice come down to the following issues:
• Commissions. You  want  them  as  low  as  possible,  but  be  careful—alow  commission  structure  may  mean  that  you  don’t  get  the  level  ofservice 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  ofyour  trading  account  may  limit  you  to  certain  low-requirement  bro-kers,  keep  in  mind  that  to  open  a  marginable  account  (required  forspread  trading)  there  is  a  minimum  $2,000  balance  requirement  be-yond any options you own. Thus you must have a minimum of $2,000
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in cash or nonmargined securities available before you even start totrade. Hence, a $2,500 opening balance would only permit you to en-ter 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 otherrequirements  may  be  in  effect.  For  instance,  how  are  good  till  can-celed (GTC) orders handled, if at all? For instance, many houses willnot 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 brokerwill automatically reenter the trade each morning, etc.). You’ll need toadjust your trading style or ﬁnd a different broker.
• Speed and accuracy of ﬁlls. This is something that is very difﬁcult to de-termine  before  opening  an  account,  other  than  by  talking  with  othertraders. However, “good” is really in the eye of the beholder—if it is prof-itable for you, then it is good, regardless of what others may think.
• Optionable  and  spreadable  accounts  available. In  particular,  makesure that in calculating margin requirements on your account that thebrokerage house gives you credit for your long position as an offset toyour short. You do not want the house to be calculating margin basedon the short position only!
• Experience  in  trading  options  in  general  and  combination  tradesin  particular. You  will  want  your  broker  familiar  with  options,  andhopefully,  with  option  strategies,  so  that  they  can  anticipate  yourneeds.
• Ability to ﬁll the order between the spread. If you place your buy or-ders at the ask and sell orders at the bid prices, will the broker rou-tinely get you a better price? If so, you can then place an order suchthat you will be ﬁlled, with the broker working the difference to getyou the best price. Online brokers typically do not do this, as every-thing 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  islooking out for your interests. After all, your broker has your money.Even if you’re only placing trades online, it is important to feel com-fortable about the ﬁrm you are dealing with on a regular basis.
Once you have chosen a broker, however, the fun begins. As you arelikely aware from your own business, there are customers or clients thatyou enjoy dealing with and others whose call you dread taking. Obviously,those whom you enjoy dealing with will get service beyond the minimumand will generally be happier with their experience than will the trouble-some customers—so, too, in the world of brokers.
Two  personal  experiences  come  to  mind  when  thinking  of  good
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brokers. In one case, we had been discussing exiting a trade for severalweeks. Finally, I put the order in. About three minutes later, I got a phonecall from my broker, saying that no, she hadn’t ﬁlled the order, but ratherhad pulled it. It seems that after sending the trade to the ﬂoor, she over-heard someone talking about a takeover rumor. On checking, she foundthat the stock was indeed in play, and in fact trading had been halted. Onreopening, the shares gapped up about $5, and that is where I would havebeen ﬁlled had she not pulled the trade. By pulling it, she enabled me towatch the stock drift up about $15 over the next week, which turned anotherwise small loss into a very proﬁtable trade. The second example is asituation  where  I  got  a  call  back  from  the  broker  checking  to  see  if  mytrade was accurate. I normally use bull positions when trading, and I hadinadvertently entered a bear spread on this particular trade. Upon check-ing, I found that indeed I had transposed my buy and sell options on thetrade. 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 con-ducted was that the customer has to have a plan, and has to articulate theplan  with  them.  What  do  you  expect  from  the  account?  What  are  yourgoals—retirement  portfolio,  current  income,  and  so  on?  What  risks  areyou willing to take? What types of trades do you like or dislike? Are thereindustries you want to avoid or to specialize in? Such information can ob-viously help them to recognize situations that may interest you.
Reviewing your account periodically with your broker is also impor-tant. Obviously, as a trader, you will be in frequent contact with your bro-ker regarding your trades, but periodically you should review your goalswith 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 bedoing. This, of course, would not apply if you were dealing only with anonline broker. In that case, it will be up to you to review your goals andyour trades to make sure you are staying on track.
Knowing what you need from the broker and asking for speciﬁc infor-mation also looms high on the list of good customer traits. If you are on aﬁshing  expedition  and  don’t  know  exactly  what  you  need,  or  what  youneed  is  not  absolutely  critical  for  this  instant,  wait  until  after  markethours  for  such  discussions.  In  other  words,  be  judicious  with  your  bro-ker’s time. In this same vein, ask questions when you are unsure. Whetherit is a deﬁnition (a “chocolate milkshake” in Chicago is a different bever-age than one in New York—i.e., different terms are frequently used for thesame concept) or it is a new strategy, ask your broker to explain it. Don’tmake guesses; your broker is willing to help. It is a lot easier to spend 30seconds in explanation up front rather than trying to unwind some posi-tion you got into by not understanding what was happening.
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The  most  surprising  comment  of  my  informal  survey  came  from  abrokerage dealing primarily in options, one where all of the brokers haveactual  trading-ﬂoor  experience.  The  comment  was  that  this  broker  pre-ferred longer-term investors. He much preferred customers who had 90percent  of  their  investments  in  long-term  positions  and  limited  theirshort-term  plays  to  less  than  10  percent  of  their  portfolio.  “Short-termtraders don’t last.”
The worst type of account, according to one full-service broker, is thecustomer 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 whocannot  make  up  their  minds,  clients  who  ask  for  advice  and  then  goaway to “think about it,” never returning with an answer, lead to frustra-tion on the part of the broker. A ﬁnal problem client is the one who ex-pects  much  service,  but  then  doesn’t  trade  with  that  broker—andinstead  goes  elsewhere.  Obviously  this  is  a  problem  faced  much  morefrequently by the full-service broker, but even the discount brokers seemto  have  such  problems.  Obviously  the  broker  understands  that  theywon’t get every trade, nor does every request for information result in atrade, but commissions pay them, so they expect some reasonable rela-tionship  between  the  amount  of  service  delivered  and  the  amount  oftrading through your account.
Finally, talk to your broker. We will assume that you let them knowwhen they make a mistake, but also let them know when they do a goodjob. Recommend them to friends and family when appropriate. Rememberthat by being a good client, you will soon ﬁnd that most brokers suddenlyget better. After all, “brokers are people, too.”
QUALITY OF EXECUTION
While  many  investors  focus  solely  on  the  dollar  costs  of  commissionswhen choosing brokers, there are other less obvious costs to be wary of.Speciﬁcally,  when  investors  place  buy  and  sell  orders,  the  quality  of  theexecution and the subsequent price at which the stock trade takes placeare equally important to consider.
For instance, if you place a market order to sell 500 shares of a stockand the broker fails to act promptly, the order might get ﬁlled for, hypo-thetically, $50 rather than $50.25 a share. In other words, a delay in exe-cuting  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
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you  are  consistently  losing  eighths  and  quarters  on  share  trades,  whocares if the trades are commission-free?
Arguably, the quality of a broker’s execution is more important thanthe commissions on trades. In fact, under federal securities laws, all bro-kers have a duty to execute orders at the best possible price. It is calledthe “duty of best execution.” Consequently, the Securities and ExchangeCommission (SEC) has stepped up surveillance of online brokers becauseof  concern  over  the  quality  of  their  executions.  Some  of  the  concernstems from a practice known as payment for order ﬂow.
In order to understand how payment for order ﬂow works, considerwhat happens from the time you submit your stock order until the time itis executed. Once the broker receives the order, they have a responsibilityunder the “duty of fair dealing” provision of the Securities Exchange Actto 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 thebest possible price.
With  payment  for  order  ﬂow,  this  isn’t  always  the  case.  Rather  thanshopping  the  order  around  to  competing  market  makers  or  electroniccommunication networks (ECNs), the order is sent to a wholesale marketmaker who, in turn, pays the broker for sending orders in their direction.In short, brokers are increasingly using preferred market makers who paythem for the buy and sell orders. Such arrangements allow online brokersto offer cheap automated trades because they also make money off the or-der ﬂow.
At the same time, large market makers, such as Knight/Trimark, some-times handle more than 30 percent of the orders in a particular stock. Asthe  high  volume  of  orders  comes  through,  the  market  makers  generateproﬁts from the difference between the bids and offers. There is no incen-tive for them to beat the prevailing market price. Therefore, by directingtrades to market makers who pay for order ﬂow rather than shopping theorder  around  to  competing  market  makers,  the  broker  is  not  assuringclients execution at the best possible price.
During a speech to the Securities Industry Association in November1999, SEC governor Arthur Levitt noted, “I worry that best execution maybe comprised by payment for order ﬂow, internalization, and certain otherpractices that can present conﬂicts between the interests of brokers andtheir customers.”
Some brokers are responding to critics of payment for order ﬂow byoffering  rebates  to  clients.  A  few  brokerages,  for  example,  do  not  pre-arrange to generate payments for order ﬂow. Instead, when they receivean order, it is routed to the best execution point. If the best price happensto be with a market maker that does pay for orders, the brokerage passesthe payment to its customers in the form of monthly rebates.
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The  practice  of  paying  for  order  ﬂow  is  providing  ammunition  forﬁrms that allow customers to bypass the traditional role of the broker.So-called  direct-access  ﬁrms  are  attacking  Web-based  brokers  head-onby  offering  technology  that  takes  orders  directly  to  the  marketplace,rather than through a broker. With direct-access ﬁrms, investors executeorders directly with market makers, exchanges, or ECNs—wherever thebest price exists. Cybertrader, Edgetrade, and E*Trade Professional arethe latest to offer the individual investor direct access to the stock mar-ket by eliminating the role of the broker. Direct-access ﬁrms are appeal-ing in that they offer the individual investor a higher probability of betterexecution. 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 toservices  like  research  and  quotes.  Bottom  line:  If  you  are  an  activetrader,  direct  access  can  greatly  increase  the  efﬁciency  and  effective-ness of your orders.
INVESTOR SAFEGUARDS
When  investing  in  the  stock  market,  your  ﬁduciary—the  ﬁnancial  agentyou trust with your money—is your broker. The SEC and the exchangesare diligent in their regulation of both brokers and their ﬁrms, but you stillneed to be aware of some of the possible indiscretions to protect againstﬁduciary fraud. First we will delineate these improper deeds and then pro-vide the reader with six ways to self-protect one’s account. Some of themost 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 certainmarket makers, you end up paying for the bribe through higher cus-tomer 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.
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• Conﬂict of interest. Arising from the brokerage ﬁrm’s role as marketmaker, 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 companiesthat minimize or avoid disclosure of their ﬁnancial condition. Alwaysread the ﬁne print in your information sources, and avoid hot tips.2. Deal with major brokerage ﬁrms and reputable brokers. Know yourbrokerage ﬁrm’s ﬁnancial condition and who owns the ﬁrm. Be sureyou 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  themwith 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  yourbroker to explain any discrepancies. If trouble persists, go to a super-visor. If it continues, change ﬁrms.
5. Change brokers who talk about sure winners. Resist all sales manipu-lation emphasizing double-digit rates of return, stocks that will dou-ble, hot stocks, and guaranteed proﬁts.
6. Never put greed before safety. Sometimes you have to protect your-self against yourself, and that can be the most difﬁcult job of all. Re-member the stock market will be here tomorrow—but to use it, youneed investment capital.
Hopefully  this  information  will  help  you  avoid  or  deal  effectivelywith any account issues that you might experience. Investors who knowhow to choose a good broker, how to analyze information, how to orderskillfully, and how to protect themselves are investors who know how tomake money.
OPENING AN ACCOUNT
The ﬁrst step on the road to being a trader is opening an account with abroker.  This  can  be  done  using  an  online  broker,  over  the  telephone,  orvisiting a brokerage in your area. Today, I ﬁnd that most traders prefer theonline route. In any event, whether you use a broker on- or off-line, youstart  by  signing  a  new  account  agreement.  This  somewhat  legal-looking
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document may have you wondering if you are setting up an account or ap-plying for a job. Nevertheless, the new account agreement is important fortwo reasons:
1. The new account form enables the brokerage ﬁrm to ﬁnd out about youand 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 agree-ment is your ﬁrst look at the broker and, because it stipulates the terms ofyour relationship with that ﬁrm, is worth reading in detail.
As soon as the account form is reviewed and approved by the broker-age ﬁrm, you can begin trading. Based on your experience level and ﬁnan-cial proﬁle, the broker may impose limits on your trading (e.g., limit theuse of credit, limit speciﬁc option strategies, or prohibit the purchase ofcertain  speculative  investments).  In  most  cases,  however,  that  will  notpose a problem.
While the actual process of setting up a brokerage account is relativelyeasy, in the long run ﬁnding the right broker who meets your speciﬁc in-vestment goals can be quite difﬁcult. After all, there are a large number ofonline brokers out there these days. Determining which one is right for youcan be a long and arduous process.
One  of  the  most  important  considerations  when  evaluating  variousbrokers is: What type of brokerage ﬁrm is it? In turn, in order to under-stand the differences between brokers, it is important to understand howthey make money. Speciﬁcally, most of a brokerage ﬁrm’s revenues comefrom  the  trading  activity  of  its  clients.  In  other  words,  each  time  an  in-vestor  buys  or  sells  an  investment  security,  the  broker  makes  moneythrough commissions.
Today,  due  to  the  sheer  number  of  ﬁrms  in  existence,  commissions(and/or sometimes fees) vary wildly. Furthermore, with the recent growthin online trading and subsequent competition, commissions have reachedhistorical lows. Some ﬁrms even let certain wealthy clients trade for free.Others,  however,  provide  speciﬁc  investment  advice  and,  therefore,  re-quire that investors pay higher fees and commissions for doing businesswith them.
As a generalization, commissions will be higher for brokers who offerspeciﬁc  advice  to  the  investor.  So-called  full-service  ﬁrms  have  ﬁnancialconsultants or ﬁnancial advisers who not only buy and sell shares on yourbehalf,  but  also  gather  information  about  your  ﬁnancial  resources  andmake speciﬁc recommendations. Other ﬁrms, sometimes called discount
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brokers, do not offer any sort of ﬁnancial advice. They simply execute buyand sell orders on your behalf at the lowest cost possible.
For instance, to buy 100 shares of a stock trading for $55, a full-servicebroker will charge between $75 and $200, while a discount broker chargesonly $10 to $20. At the same time, a full-service broker will place the orderin context of your personal ﬁnancial situation and, if you request, offer ad-vice as to whether it is a suitable investment for you. A discount brokerwill  simply  complete  the  transaction  according  to  your  instructions.Charles Schwab and E*Trade are examples of discount brokers. If you arereading this book, chances are you will be a self-directed investor and itwill not make much sense to use a high-priced broker. Instead, you will fo-cus on online ﬁrms that specialize in options trading and have relativelylow commission schedules.
THE OPTIONS ACCOUNT
Believe  it  or  not,  one  problem  new  traders  sometimes  face  is  not  beingable to obtain permission to trade options from a broker. Clients of bro-kerage ﬁrms who want to trade options are required to complete an op-tions  approval  form  when  opening  new  accounts.  The  options  approvalform is designed to provide the brokerage ﬁrm with information about thecustomer’s experience, knowledge, and ﬁnancial resources. According tothe  “know  your  customer”  rule,  options  trading  ﬁrms  must  ensure  thatclients  are  not  taking  inappropriate  risks.  Therefore,  the  new  accountform and the options approval document gather appropriate backgroundinformation about each customer.
Once the documents are submitted, the compliance ofﬁcers within thebrokerage ﬁrm determine which speciﬁc strategies are appropriate for theclient. The process is designed to ensure that inexperienced traders do nottake inappropriate risks. For example, if the option approval form revealsthat  the  client  has  little  or  no  options  trading  experience,  and  then  theclient goes on to lose large sums of money via complex high-risk trades,the brokerage ﬁrm could potentially face regulatory and legal troubles fornot  knowing  its  customer.  So,  each  brokerage  ﬁrm  is  required  to  under-stand the client’s experience level and ﬁnancial background to ensure thatthe customer is not trading outside of certain parameters of suitability.
An  individual’s  past  options  trading  experience  and  ﬁnancial  re-sources will allow him or her to trade within certain strategy levels. Forinstance, level 1 strategies include relatively straightforward approacheslike covered calls and protective puts. More complicated trades, however,require a higher level of approval. Table 12.1 shows a typical breakdown a
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TABLE 12.1 Typical Brokerage Firm Breakdown
Strategy
Level 1
Level 2
Level 3
Level 4
Level 5
Options Trading Level
✔
✔
✔
✔
✔
Covered call writing
Protective puts
Buying stock or index puts and calls
Covered put writing
Spreads
Uncovered put and call writing
Uncovered writing of straddles and strangles
Uncovered writing of index puts and calls
✔
✔
✔
✔
✔
✔
✔
✔
✔
✔
✔
✔
✔
✔
✔
✔
✔
✔
✔
✔
brokerage  ﬁrm  might  use  to  group  strategies  by  levels.  Traders  with  agreat deal of experience and signiﬁcant ﬁnancial resources can generallyreceive approval for level 5 trading. This would allow them to implementany type of trading strategy, including high-risk trades like naked calls anduncovered straddles.
Although the options approval levels can vary from one broker to thenext,  level  3  is  enough  for  most  readers  following  the  strategies  in  thisbook.