Individuals look to a brokerage
firm to provide a financial function much as they do when choosing a bank.
It is another form of a financial institution. Brokerage firms
generally come in two 'flavors,' a full-service firm or a discount firm.
Before the personal
computer, for a person to have a broker, was like having a chauffeur or
butler. There were no discount firms, technology was expensive and
only the largest firms had access to the financial exchanges. A
brokerage account was basically for the 'rich.' In the late 1970's,
the personal computer and related technology drove down the price of
computing power, brought that power into people's homes and a technology
boom began. Stock prices rose quickly, attracting a lot of attention,
more individuals wanted to invest, brokerage firms expanded. [This is
when the mutual fund industry absolutely took off! From about 400
funds, the number swelled to over 8000 today; mutual funds hold literally
trillions of dollars of investor's money.]
The typical full-service
firm would charge 3% commission on the value of the trade. 100 shares
of $100 stock, a $10,000 trade, would cost $300 in commission. When
discount firms were introduced, they charged 1% commission. Both
full-service and discount-firms began to expand into another areas of
traditional banking, capturing checking accounts, savings accounts, offering
credit cards, debit cards, monthly statements, etc. and generally being a
one-stop-financial-shops for individual investors. The single biggest
difference between these firms is that the full-service firm, by definition,
introduces the investor to a broker, a broker that 'knows his client,' has
spoken to his client, understands the client's account, risk tolerances,
etc. The full-service broker offers ADVICE. The discount
firm offers a commission discount because they do not offer individual
advice to the account holder. In a discount-broker relationship, the
account holder is making their own investment decisions. Not to
trivialize the relationship between a broker and their client with this
example, but some people want to change the oil on their car themselves,
others prefer someone else to do it!
BOTH Full-Service and Discount
Firms offer a full line of banking services. Some are:
EXAMPLES OF FULL SERVICE FIRMS:
Merrill Lynch, Salomon Smith Barney.
EXAMPLES OF DISCOUNT FIRMS:
Charles Schwab, Fidelity Investments, Quick & Riley.
To give an example on how
successful brokerage firms have been, they were said to hold 75% of the
nation's wealth, the other 25% is left to banks, and other financial
intermediaries.
On a final note,
commissions have been driven down drastically over time. A discount
broker that I am familiar with allows trades up to 1000 shares, at any share
price for $8 per trade. An account holder could buy 1000 shares of
$250 stock (a $250,000 trade) and pay a flat $8 in commissions!
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More about the broker:
A broker, by definition, is a go-between. When a client of the firm wants
to buy 100 shares of XYZ stock, the broker finds a seller on the Stock
Exchange. The broker is paid a commission for the service.
Brokers have specialized over
time, focusing their knowledge and familiarity on sections of the market much
like a physician would specialize on certain areas of medicine.
A broker is a licensed
professional. When one is first interested in this as a profession, you must
be hired by a firm, then to be registered, you must pass an examination or series
of examinations to be licensed by the Securities and Exchange Commission (SEC).
A Series 6 exam is one that
most insurance agents take. It allows those who hold a Series 6
license to speak to clients about annuities and mutual funds. The
coveted Series 7 license is a 'full' registered representative (a full
broker) licensed to speak to clients about individual securities (stocks,
bonds, etc.) in addition to mutual funds.
A broker's income is based on
commission. As described above, they are paid when trades are made.
They share the total commissions charged to the client with the brokerage firm.
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Opening an Account:
The
CASH Account is the most common. Very simple. Everything is on a "cash"
basis - All orders must be paid in full by
the settlement date, 3 days after the trade is made. If you have the cash
in the account at the time of the trade, the firm will simply debit your cash
position and purchase the securities that you asked them to purchase for you.
In the case of selling securities, they would deposit the sale proceeds into
your cash position for a future trade or send the money to you at your request.
Alternatively, an investor can
apply for a
MARGIN Account. By regulation, this requires a $2000 minimum account balance. You may
margin
(borrow) 50% of the purchase of a security. For a $10,000 trade, you need only
$5000 in cash, the brokerage firm will loan you the other $5000. This
ratio of a 50% equity position is watched carefully. A person using margin
to buy securities is leveraging their portfolio, obviously believing that
the purchased security will rise in price, more profit could be made if some of
that profit was earned using the brokerage firm's money. If, however, the value
of the margined security falls in price, at 35% equity, the brokerage will issue
a margin call. This places the investor on notice that the
required 50% equity level is not being maintained and requires the investor to
deposit cash or other marketable securities to bring the equity in the account
back to the 50% level. If the investor fails to bring in the required
capital, the firm can sell the securities to payoff the loan. If equity
falls to 25%, the brokerage firm will SELLOUT the account. At 25% equity, Federal Reserve Regulations
are forced on the firm. The process of watching a margin account and
matching the required equity position is called
being "marked-to-market." Go to
www.investopedia.com and look in their
dictionary under "margin."
Margin is a difficult subject in
investments. The basics were described above. Believe it or not, the
two biggest reasons that a person will fail the Series 7 exam (to become a
broker) is Options and Margin (in that order). In our lectures, were are
scratching the surface but covering the most important part of the subject.
Brokerage firms charge interest
on the borrowed money. Look in the Wall Street Journal under "Money Rates"
and find "Call Money." That is the rate that the firm will charge you.
Remember that Margin is
credit, by definition, you can buy ANYTHING with margin, not just
securities. I have know investors to buy cars, vacations, refinance
credit cards, etc., using their margin accounts. It is simply using
the equity in your investments to borrow money.
Click here for a sample of
what a brokerage firm will send a margin client:
Margin Accounts
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PLACING A TRADE:
Some lingo first: If you are LONG a security, means you own it. When
a broker, investor or someone on the business news says that they are 'long' GM,
this means simply that they have, at some point, purchased GM stock and they
still own it. If they were to sell the GM stock that they have, they would
(1) no longer be long GM, and they would have (2) completed a 'round trip.'
A simple concept. Example: You live in New Orleans, go to Miami and
return to New Orleans, you have made a round trip. To execute a "round trip"
you first BUY the security, then when ready, execute a SELL order.
Ideally, you buy LOW and sell HIGH. Sounds simple enough but not taking
the process for granted, you are buying because you believe the security will
RISE in price. You are making money as prices increase. An investor
that buys a security 'signals' that they believe the security is undervalued and
they believe it will rise in price. Remember what was said a few
paragraphs ago, when you buy (you think the shares will rise in price), someone
else is selling (thinking that the shares will fall in price).
Market Order - The most common order. Buy or sell at current "market" price.
This order implicitly instructs the broker to purchase the security as quickly
as possible. That you are "not concerned about the price, but the speed of
the execution." The broker will send the order to the exchange where
your shares are traded and BUY at the prevailing market price. Whatever
the price is when the trader or computer gets there, is the price that you will
get.
Limit Order - Sets sell or buy limits that an investor will accept.
This is somewhat opposite of the Market Order. The limit order implicitly
instructs the broker to buy at a particular price. That you are "concerned
about the purchase price and not the speed of the execution." A limit
order may never be executed. Order can be good for the day (A Day order)
or Good Until Cancelled. Say that IBM is trading at $100 per share.
You contact your broker and ask to buy IBM. "Aat-the-market?" is what you will
be asked. "NO, not at the market, buy with a limit of $95." The
broker will enter the limit order into the computer and there it will sit until
IBM's price falls to $95; at that point, it will be released into the trading
crowd and become a market order.
Stop Order - Protect a profit or stop a loss (stop loss). For
example, you purchase a stock for $60 per share, you immediately set a stop loss
for $57 per share. The idea being that you allow for some volatility in
the stock but want to risk no more than three points. If the shares fall
to $57, the computer will release the order into the trading crowd and it will
be a market order.
Short Sales: See short selling at:
http://www.investopedia.com/terms/s/shortselling.asp
Short selling tends to confuse
even though it shouldn't. It is the opposite of being "Long."
[Review the paragraph above about being "long" a security.] Wall Street
gives us a way to profit from falling securities prices, by executing a
round trip (buy and sell), in reverse. Short
Selling is act of selling borrowed securities. In a short sale, you
contact your broker or get onto your computer a sell a security that you do not
own. You borrow the security from your broker and then sell it. A
short seller is hoping that the price of the security will fall. If it
does so, the short seller will then buy back the security at a lower price to return them to their
broker. Short sellers make money as markets are falling. To
short sell, you must have a margin account.
