One of your more important decisions when trading futures and related options is the broker you will use. Some time ago, choices were limited by fixed exchange margins and commission rates. All brokers were required to adhere to the same schedule of fees and margins established by the exchanges. When fees were deregulated, investors were treated to a wide range of services. Today, you can trade through a discount broker, use “full service,” or even place orders electronically through the Internet.
Your decision concerning brokerage is extremely important because your profit performance can be affected. Commission rates can be as low as $15 per round-turn at a deep discount broker if you maintain a high trading activity and healthy account balances. More common discount rates range from $25 to $40. Full service commissions usually begin around $40 and can be as high as $125. A “round-turn” commission refers to a completed transaction; into and out of the market. Some brokers may charge you on a “half-turn.” For options, some brokers may charge the full commission when you enter your trade and nothing when you exit.
While logic dictates that “you get what you pay for,” this is not always the case when seeking brokerage services. Some discount firms provide excellent support. Some “full service” companies can be disappointments. The criteria for selecting whether to use discount or full service depends upon the support you need and the service you desire. Some traders want nothing more than an order desk… no comments, opinions, or information. This is ideal for using a discount firm. Moreover, the greater the discount, the better.
On the other hand, you may want help in placing your order or understanding market conditions. You may seek an opinion or an explanation of how to use stops and limits. In such a case, full service can make more sense. Regardless of whether you use discount, full service, or something in-between, you want an efficient firm that will provide good execution performance. Because commodity and option prices can move very quickly, your executions or “fills” can vary from minute to minute or from one broker to another. This is because different brokerage firms may use different order processing routines.
You may be familiar with the term, “at the floor.” This refers to placing orders directly with floor traders. This is usually considered the most time-efficient method of entering trades. However, the floor is usually a very busy place. It is not likely that you will be allowed to chat if you are truly “going to the floor.” Most brokerage firms have an “order desk.” This is a department of experienced trading clerks or brokers who receive your orders and call them to their floor brokers. This is normally considered the second most time-efficient way to trade. Again, trading desks are very busy and don’t usually have time to discuss your trade. When going to the floor or using a trading desk, you should be well organized. Make sure you don’t double-enter a trade or forget to cancel a stop when leaving a market. Neither the floor broker nor the trading desk have time to check for your errors.
The most common association is with a personal broker. This is a relationship where the broker knows you and your trading style. Your broker monitors your account and is familiar with your positions. Certainly, you must remain well organized and avoid errors even if you have a personal and responsible broker. However, your broker can frequently catch possible problems and he or she clearly has an incentive to help you trader better to continue earning commissions. Your personal broker takes your orders and calls them to the floor or sends them through his own desk for execution.
If you use a personal broker, you are likely to pay a higher commission. Of course, if you have a large account with high volume, your rates may be lowered to near or at discount. The most important criteria when choosing a broker is honesty. It is often a good practice to call the National Futures Association for a background check. Find out if there are any complaints or disciplinary proceedings filed. Determine the nature of any such problems. Be careful in your evaluation of any broker. Keep in mind that a sanction for a bookkeeping error is far less significant than a suspension for a ponzi scheme! If a broker you are considering has a problem on the NFA record, ask the broker for an explanation.
Most brokers are honest and hard working. Therefore, the next criteria is experience. There is no substitute for experience… The longer the better! Experienced brokers are familiar with all types of orders, strategies, and market conditions. They are less likely to panic and more likely to direct you to the right action under most circumstances. Some of the best professionals are those who have multi-level experience. You may have heard the distinction “upstairs” and “downstairs” traders. An upstairs trader is one who works in an office away from the exchange trading floor. A downstairs trader is on or close to the floor.
If you can find a broker who has worked on the floor of the exchange as well as in an “upstairs” environment, it may be helpful. Having floor trading experience gives insight into the way trades are processed and how the “system” works. Obviously, there are many highly qualified brokers who have never worked or even seen the trading floor. Yet, floor experience is simply one more aspect you might look for when selecting the broker or firm where you’ll trade.
Another point to review is the registration status of the brokerage firm. There are several types of brokerage companies including:
Guaranteed Introducing Brokers
Self-Guaranteed Introducing Brokers
Clearing Member Brokers
Non-clearing Member Brokers
Introducing Brokers (IBs) are similar to selling agents for the larger “Futures Commission Merchants” (FCMs). Those IBs that are guaranteed have an exclusive relationship with an FCM that is willing to use its capital to “guarantee” the IB. A self-guaranteed IB must maintain its own minimum capital and can trade with one or more FCMs. While the term “self-guaranteed” may sound less financially secure than guaranteed, these IBs are generally very stable by virtue of their willingness to maintain their own capital base. The National Futures Association (NFA) maintains strict financial requirements for non-guaranteed firms and carefully monitors compliance.
During the financial uncertainty over the October 1987 Crash, it was observed that IBs acted quickly to protect clients against the possibility of failures by the FCM. This was a highly unusual situation, however, it demonstrated that the loyalty of an IB is with its client base. This is not to say that an FCM is any less loyal to its clients. It simply illustrates that an IB can seek to move its clients if the FCM exhibits financial instability or poor performance.
IBs use the facilities of their supporting FCMs. FCMs maintain order desks and relationships with floor brokers. Floor brokers may be independent or can work for the FCM. FCMs may own seats on the exchanges. This affords extra privileges including access to exchange resources and better commission rates for the member firm. (Note: Member firms do not always pass on the lowest rates to customers.) Clearing members are an elite group of FCMs that maintain very large capital deposits with exchange clearing firms. Clearing deposits are used to guarantee transactions in the unlikely event of a default by both the trader and the member firm. The clearing house provides the last line of defense against defaulted transaction through its clearing fund.
When considering a brokerage company, find out the registration status. See how the firm’s standing might affect your trading account. Do you need to go to the floor with your orders? Can you use the trading desk? Do you have a relationship with a retail full-service full-product company? Does it make sense to use a firm specializing in futures? These are important questions.
Commodex trading tends to generate a large number of trades. Therefore, commission expenses are an important consideration. Commodex automatically deducts an average commission of approximately $40 per trade from the PROFIDEX figures. A $10,000 account following a modest Commodex portfolio can experience between four and six trades per month. At $40 per trade, commissions can range between $160 to $240 per month. Over a year, that’s $1,920 to $2,880… 19.2% to 28.8% of the account equity. A $10 difference in commission rate translates into $480 to $720 per year. Therefore, it is easy to see how commissions can impact your trading.
Of course, bad fills can be far worse than higher commissions. Consider that a one-tick differential in treasury bonds represents $31.25. If a broker charges $60 in commission and consistently achieves better treasury bond fills by one or two ticks, it is obvious that you are getting a good deal. A very low rate with bad fills is no bargain!
One of the best rules in commodities is to “know your broker” and make sure your broker knows you. When you fill out your account papers, be as clear and honest as possible. Never exaggerate your financial statistics such as net worth or the amount of risk capital you have. Be very cautious and avoid brokers who suggest being less than truthful on your account forms. Read your forms carefully and ask for an explanation on any item you don’t fully understand. Your decision to trade futures and related options is important. You must enter into a contractual relationship that has many rights and obligations.
Commodity futures markets are exciting and potentially rewarding. A good relationship with your broker will enhance this experience.