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. More importantly you should determine 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. There is far more money to be made in the markets than could ever be “saved” in commission. Similarly, a seasoned trader wouldn’t want to choose a firm that focuses on high-end service with a hefty price tag. Ideally, the perfect firm for most traders is one that finds a happy medium between competitive rates and exceptional service.
IB or FCM? (Introducing Broker or Futures Commission Merchant)?
There are a lot of misconceptions as to what the difference is between an IB (Introducing Broker) and an FCM (Futures Commission Merchant) and how those differences will impact the clients trading practices. We would like to take this time to set the record straight.
According to the Chicago Mercantile Exchange, an 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. To clarify, an FCM is a brokerage firm (typically a large one but it doesn’t have to be) that is capable of accepting money in the name of clients to hold as margin for trading activities.
The formal definition of an IB is a firm or person engaged in soliciting or accepting and handling orders for the purchase or sale of futures contracts, subject to the rules of a futures exchange, but not in accepting any money or securities to margin any resulting trades or contracts. The IB is associated with a correspondent futures commission merchant and must be licensed by the CFTC.
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, the FCM executes trades on behalf of the client. An IB doesn’t accept client money in its own name; instead all client monies are sent 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 clearing trades with the exchange, issuing statements and platform maintenance; but a quality IB will be able to assist you in many of the day to day activities. Simply put, your IB is your point of contact so you should always refer to your broker first and FCM second should you have a question or require assistance.
Along with customer account statements, the FCM is responsible for issuing the end-of-year-tax reporting (1099’s) documentation. 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 so, traders using an IB as their broker assume 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 have established clearing arrangements with multiple FCMs and they can choose to drop or add FCM’s in which trades are cleared at any time. Should your broker (IB) opt to stop doing business with an FCM, your account will follow the broker to its new clearing arrangement in a transaction known as a “bulk transfer”; unless, of course, you specifically object. 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 brokers working directly for an FCM insinuate 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 may 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, 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.
This is largely in part to the common business practice of FCM's allowing full service brokers to set their own commission schedules, within pre-approved boundaries, combined with 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, or even more affordable, 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 handle your account efficiently.
Brokerage Firm Specialization of Discount, Full-Service, or Both
There are firms that offer a blended array of services and others that specialize in either full-service or online discount trading. Others are designed to provide a balanced blend of both levels of service, and even hybrid brokerage accounts in which traders can have multiple service levels and strategies within a single trading account. 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 aren’t truthful with yourself, how could you possibly be objective in choosing which services are best for you?
Once you have determined what you are looking for, there are a few things that you should keep in mind. Based on my observations, it seems like 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 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.
Imagine inadvertently entering a highly illiquid market and experiencing trouble offsetting your trade (exchanges will reject market orders if there isn't anyone to take the other side of your trade). A deep discount brokerage is often short staffed, with less than skillful brokers who may not have the knowledge or exchange contacts to help you through your predicament. In fact, many discount firms hire salesmen rather than experienced brokers. If you don’t believe me, look at Craig’s List employment ads I the Chicago area; at any given time you will generally find broker recruitment ads which mention job requirements of sales experience but mention commodity industry knowledge as an option requirement in a side note.
The hindrance of an inexperienced staff doesn’t only come into play if you make a mistake and need help correcting it. What if your internet connection fails and you find yourself on hold waiting for a representative of a deep discount brokerage firm while the market may be going wildly against your position? These are somewhat extreme circumstances and are not everyday occurrences, but what I am trying to point out is that it may be worth paying slightly more in commission than "paying" far more in market losses.
Blanket Commission Structure or Variable
As a retail account you must understand that while all brokerage firms want business, each client account they accept poses a significant risk to the firm. This is due to the fact that 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 customer account balance with the exchange immediately. Believe it or not, your individual broker is expected to cover your negative account balance with 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 to compensate for the risk. 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; they assess the compiled data on you to determine 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 insurance 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 for a health insurance policy as an avid jogger with identical coverage. Simply, the smoker would be paying less than he should 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. Efficient 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, regardless of account size.
Understanding these basic concepts of commission and how brokerage firms assess risk it should be obvious that in most cases it is preferable to trade with a firm that offers a flexible rather than a fixed commission structure. Doing so ensures that you are getting a fair rate, and likely an appropriate service level, based on your needs as a client.
Those firms offering blanket, and typically very low, commission rates are most likely cutting corners in risk management. This might not seem to be a concern to you, but it will have a profound impact on your trading experience. For instance, firms offering deeply discounted commission rates face low profit margins. To compensate for this, they are willing to accept very little client trading risk. Thus, they tend to force liquidate their customer’s trades at any sign of trouble. I’ve spoken to multiple clients that have experienced unnecessary losses at the hands of a heavy handed brokerage firm risk manager. In the end, it is quite possible that the market losses in such avoidable events far surpass any savings in commission they might have temporarily enjoyed.
Futures and Options Trading Platforms
A good brokerage firm will offer its customers multiple trading platforms, with various specializations. Generally, there will be at least one “free” platform and several “paid for” premium platforms. It is generally assumed that the free platforms are sub-par, and at some firms this is the case. Nevertheless, there are some very capable free platforms that will fit the needs of most options and futures traders.
As you begin your search for an appropriate platform, keep in mind that not all futures platforms offer options on futures trading. If this is something you will eventually be seeking, you might as well go with a platform that offers it from the get-go.
If you are a position trader, trading platforms might not be a high priority. For position traders, simply having the means of easily placing trades, viewing futures and options quotes along with commodity charts, and the ability to monitor the account balance is sufficient. There is no need to complicate things unnecessarily.
On the contrary, if you are scalping, or implementing any other form of day trading strategy, 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 have some homework to do. Most platforms offer demo trading accounts in which you can test-drive platforms determine which is preferable to your needs.
I recommend that you speak to a broker about platforms. A skilled broker will be able to assess your needs and make appropriate recommendations. Doing this will save you a lot of unnecessary leg work and the frustration of making the wrong decision.
Commodity Broker Customer Service
Although you will be primarily in contact with your individual broker, you should have a good idea of what type of service the firm itself is capable of offering in your broker’s absence. Emergencies do arise, and occasionally a vacation.
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 IB, not the FCM.
IB and FCM 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 the 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.
Your ultimate experience may be determined in large part by the individual broker that is handling your account. A practiced broker will be capable of delivering efficient execution and platform support, along with 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.