Trading

Bid, Offer, and Spread

If you want to buy or sell a stock or other security on the open market, you normally trade via agents on the market scene who specialize in that particular security. These people stand ready to sell you a security for some asking price (the "offer") if you would like to buy it. Or, if you own the security already and would like to sell it, they will buy the security from you for some price (the "bid"). The difference between the bid and offer is called the spread. Stocks that are heavily traded tend to have very narrow spreads (as little as a penny), but stocks that are lightly traded can have spreads that are significant, even as high as several dollars.

So why is there a spread? The short answer is "profit." The long answer goes to the heart of modern markets, namely the question of liquidity.

Liquidity basically means that someone is ready to buy or sell
significant quantities of a security at any time. In the stock market, market makers or specialists (depending on the exchange) buy stocks from the public at the bid and sell stocks to the public at the offer (called "making a market in the stock"). At most times (unless the market is crashing, etc.) these people stand ready to make a market in most stocks and often in substantial quantities, thereby maintaining market liquidity.

Dealers make their living by taking a large part of the spread on each transaction - they normally are not long term investors. In fact, they work a lot like the local supermarket, raising and lowering prices on their inventory as the market moves, and making a few cents here and there. And while lettuce eventually spoils, holding a stock that is tailing off with no buyers is analogous.

Because dealers in a security get to keep much of the spread, they work fairly hard to keep the spread above zero. This is really quite fair: they provide a valuable service (making a market in the stock and keeping the markets liquid), so it's only reasonable for them to get paid for their services. Of course you may not always agree that the price charged (the spread) is appropriate!

Occasionally you may read that there is no bid-offer spread on the NYSE. This is nonsense. Stocks traded on the New York exchange have bid and offer prices just like any other market. However, the NYSE bars the publishing of bid and offer prices by any delayed quote service. Any decent real-time quote service will show the bid and offer prices for an issue traded on the NYSE.

  Discount Brokers

A discount broker offers an execution service for a wide variety of trades. In other words, you tell them to buy, sell, short, or whatever, they do exactly what you requested, and nothing more. Their service is primarily a way to save money for people who are looking out for themselves and who do not require or desire any advice or hand-holding about their forays into the markets. This article focuses on brokers who accept orders for stock, stock option, and/or futures trades.

Discount brokering is a highly competitive business. As a result, many of the discount brokers provide virtually all the services of a full-service broker with the exception of giving you unsolicited advice on what or when to buy or sell. Then again, some do provide monthly newsletters with recommendations. Virtually all will execute stock and option trades, including stop or limit orders and odd lots, on the NYSE, AMEX, or NASDAQ. Most can trade bonds and U.S. treasuries.
Most will not trade futures; talk to a futures broker. Most have margin accounts available. Most will provide automatic sweep of (non-margin) cash into a money market account, often with check- writing capability. All can hold your stock in "street-name", but many can take and deliver stock certificates physically, sometimes for a fee. Some trade precious metals and can even deliver them!

Many brokers will let you buy "no-load" mutual funds for a low (e.g. 0.5%) commission. Increasingly, many even offer free mutual fund purchases through arrangements with specific funds to pay the commission for you; ask for their fund list. Many will provide free 1-page Standard & Poor's Stock reports on stocks you request and 5-10 page full research reports for $5-$8, often by fax. Some provide touch-tone telephone stock quotes 24 hours / day. Some can allow you to make trades this way. Many provide computer quotes and trading; others say "it's coming".

The firms can generally be divided into the following categories:

"Full-Service Discount"
Provides services almost indistinguishable from a full-service broker such as Merrill Lynch at about 1/2 the cost. These provide local branch offices for personal service, newsletters, a personal account representative, and gobs and gobs of literature.
"Discount"
Same as "Full-Service," but usually don't have local branch offices and as much literature or research departments. Commissions are about 1/3 the price of a full-service broker.
"Deep Discount"
Executes stock and option trades only; other services are minimal. Often these charge a flat fee (e.g. $25.00) for any trade of any size.
Computer or Electronic
Same as "Deep Discount", but designed mainly for computer users (either dial-up or via the internet). Note that some brokers offer an online trading option that is cheaper than talking to a broker.
Here are some examples of firms in various categories:

Full-Svc. Discount Discount Deep Discount Computer
Fidelity Ameritrade Brown E*Trade
Charles Schwab TD Waterhouse Scottrade
Vanguard

The rest often fall somewhere between "Discount" and "Deep Discount" and include many firms that cater to experienced high-volume traders with high demands on quality of service. Those are harder to categorize.
All brokerages, their clearing agents, and any holding companies they have which can be holding your assets in "street-name" had better be insured with the S.I.P.C. You're going to be paying an SEC "tax" (e.g. about $3.00) on any trade you make anywhere, so make sure you're getting the benefit; if a broker goes bankrupt it's the only thing that prevents a total loss. Investigate thoroughly!

In general, you need to ask carefully about all the services above that you may want, and find out what fees are associated with them (if any). Ask about fees to transfer assets out of your account, inactive account fees, minimums for interest on non-margin cash balances, annual IRA custodial fees, per-transaction charges, and their margin interest rate if applicable. Some will credit your account for the broker call rate on cash balances which can be applied toward commission costs.

You may have seen that price competition has driven the cost of a trade below $10 at many web brokers. How can they charge so little? Discounters that charge deeply discounted commissions either make markets, sell their order flow, or both. These sources of revenue enable the cheap commission rates as they profit handsomely from trading with your order or selling it to another. Market making is the answer.

In contrast, Datek is one of a kind. Datek owns the Island, an electronic system that functions as a limit order book that gives great order visibility and crosses orders within it as well as showing them to the Nasdaq via Level II. Datek charges a fee from Island subscribers to enter orders into their system. Island is their outside revenue, and is far superior to selling order flow. Island is good for the customer, selling order flow like the others is not.

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