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Thursday, 30 April 2015

How Brokers Work

Newsletter 14

Basic Trading Concepts Defined

When most people hear the word “broker,” an inaccurate image often swims into their minds. They imagine a professional individual sitting in a bank, buying and selling stocks for his or her clients. While you can still find broker services that give their clients investment advice and manage their portfolios, when we talk about brokers, we are referring to online brokers.

Online brokers serve as an intermediary between you and the market exchanges in return for a commission.

There has been a record-breaking increase in online brokers opening their doors to retail investors. And you will find that there are two main types of brokers: those who put your order directly in the market exchange, and those who take the other side of the trade. Some brokers will offer both options, so it is your choice as to which one suits you.

It will not be easy to find out which model the broker uses, as sometimes they use hybrid models or complicated algorithms. The best way is to ask them directly, look at the minimum account requirements, see if they offer price depth, and know what type of commission model they have.

 

Online Brokers

An online broker serves as an intermediary between you and the market exchanges in return for a commission.

Electronic Communication Broker (ECN) / Non Dealing Desk

Electronic Communication Brokers offer direct market access by using automated systems that match buy and sell orders with other market participants. They match your trade with a counterpart that can be anyone from retail investors to banks, to brokers and other financial institutions.

It is important to understand that trading directly with the exchange and skipping the online broker is practically impossible as a retail investor. It requires a large amount of capital, and the individual trading needs to be a regulated broker-dealer who is connected to the clearing firm. As this is rarely the case with most people who want to trade, the broker is the intermediary who places orders in the exchange.

ECN Brokers offer direct market access, and they do this by using automated systems that match buy and sell orders with other market participants.

 

DMA and One-Touch DMA

There are two types of direct market access: True DMA and One-Touch DMA. The main difference is that there is no last look—no human intervention—with True DMA. When you place a trade using True DMA, the broker’s computer places your trade automatically to the exchange. When a broker uses One-Touch DMA, an actual person has to click a button for your trade to get placed on the exchange.

As you have probably worked out, when using One-Touch DMA, your trade can incur a loss of speed when trying to open or close a trade with your broker. So, why doesn’t every trader use True DMA, you may be asking? Some countries do not allow the use of True DMA—they make it obligatory that a human checks the trade before placing it on the exchange (due to fraud or not enough funds to cover the position, for example).

There are two types of direct market access: True DMA and One-Touch DMA. There is no human intervention when a trade is placed on the exchange through True DMA. There is with One-Touch DMA.

These types of brokers usually offer a win/win business model. If the trader is consistently profiting from the financial markets, he will trade regularly. This is beneficial for the broker, as he receives the trader’s commission per transaction.

 

So how does it work?

Client places sell trade on broker platform

Client places buy trade on broker platform

Broker sends the order to the exchange

Broker sends the order to the exchange

Trade is placed on exchange

Let’s take an example of a local market place:

  1. You want to buy a boat directly from the boat manufacturer, but only employees can buy boats from the manufacturer.
  2. You happen to know someone who works there. He agrees to buy a boat for you but with the condition that you pay him a fee for his services.
  3. You agree, and he buys the boat for you for $200,000. You pay him a $6,000 fee.
  4. After a few months, the boat suddenly goes up in price.
  5. As a smart entrepreneur, you think you can make a profit by selling your boat at a higher price.
  6. You call your friend again, and he says that he knows someone who will buy your boat. You agree on a fee for him again.
  1. The friend sells your boat for $270,000, and you pay him a $6,000 fee.

In the analogy above, you can see that the employee in the boat-manufacturing company can be seen as a broker, and the fee can be seen as the broker’s commission.

 

Pros

o Lower transaction costs due to no human intervention.

o Lower spreads, because the spreads vary and brokers do not touch the spreads. This allows you to trade the spread. (The spread is the difference between the sell price and the buy price.)

o Quicker executions on trades, as they don’t have to go through an intermediary.

o Less chance of human errors and issues.

o Most brokers offer anonymity. This assists bigger traders, as no one can see their strategies, and others cannot anticipate their trades and take the opposing side.

o Price depth is usually available (level 2 prices).

o Transparent broker commissions. When you are trading DMA, the broker will usually charge you a separate commission. This increases transparency.

 

Cons

o There is no fixed spread, and it is more difficult to calculate an exact exit, as the spread varies.

o Less margin is generally available.

o Bigger trading account is needed.

o Limited financial products are available.

o Education is not usually offered by these types of brokers.

 

To be continued on Monday.

Reference: Jack Maverick

PS: Jack Maverick is a long term trader who came up with an interesting strategy which makes him a profit every day. We thought, that is something worth looking into.

Especially if you are a starting trader, managing risk and protecting your precious investment is key in your start-up and daily trading.

Find out more here

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