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The Beauty of Online Trading
by: Russell Wasendorf, Sr.
The Internet and the wham-bam instant gratification it has spawned has transformed the markets. The day is fast approaching when investors and traders will not settle for less than a fully democratized trading scenario. Once the playground for stock day traders only, online trading in U.S. futures still has a way to travel. But, there’s no going back.
The beauty of online trading is that you can do it any place and at any time.
Flexibility has become the norm, as the Mario Brothers videogame generation grew up virtually teething on a joystick and computer mouse. The Gen X’ers, impatient with old, more relaxed ways of doing things that their Baby Boomer parents lived with for years, gobbled up technology on all fronts. Today, for those X’ers with moxie and the means to trade stocks, futures and options, no longer is anything less than a 24/7 mentality acceptable. And then, of course, these “whiz kids” in turn have helped their parents turn the corner and embrace innovation. Even old dogs are learning new tricks. Instant gratification is the watchword. Enter online trading.
Online trading technology, combined with many exchanges’ moves to electronic trading platforms in part or in whole, has not only changed the way customers enter orders. It has fundamentally changed the investment world. Customers have gained far greater control over the way their orders are handled. This empowerment has dramatically democratized the markets as never before.
Initially, electronic order entry simply replaced the account executive by replicating, electronically, what the account executive would have done physically. Traditionally, futures (and stocks and options) orders were placed through an account executive who acted as an intermediary between the customer and market makers on the trading floor. The account executive placed the order, received the fill and notified the customer.
Today, from the comfort of their own homes, customers can either connect to an electronic trading platform like Globex at the Chicago Mercantile Exchange, a/c/e at the Chicago Board of Trade or, at the very least, have their orders routed much more quickly than was possible just a decade ago.
Additionally, many of the exchanges have really made the time aspect of trading as flexible as anyone would want, with many markets available virtually 24 hours a day for the worldwide trader with insomnia. Not only that. The limited number of markets accessible electronically just ten years ago pales in comparison to the wide array now listed today. And, unlike ten years ago, fully electronic exchanges in both the securities and futures world are challenging the more traditional exchanges and taking business away.
There are reasons for this shift. When online systems hook the customer directly to an exchange’s electronic trading engine, a customer can place an order, have the order transmitted directly to the trade-matching engine and, at the end of the loop, have the fill reported directly back to the customer. In many instances, this electronic communication is completed in a fraction of a second. Further, as order-entry systems became more sophisticated, a broader array of order types became available to the customer, along with more detailed information. Because the order-entry system is directly connected to the electronic trading engine, a REAL “real-time” price can be transmitted back to the customer.
As even greater sophistication developed for the online systems, the capability of reporting the “book” became possible. The “book” is the roster of resting orders above and below the market; the price is indicated along with the quantity for bids and offers. This book gives the electronic trader a market view similar to the vision a pit trader would have scanning the pit to see who is trading at what price and what quantity.
Giving the customer access to the real, real-time prices, a view of the book, and the immediate response to the order placed all have dramatically leveled the playing field for all electronic traders.
For the brokerage firms that serve the online trader, a new dynamic has been created and, with it, a new economy. The technologies of online trading have enabled the market intermediaries (brokerage firms) to efficiently handle a large volume of transactions with less staff and far fewer errors. For many firms, online orders are not just seamlessly transacted but seamlessly booked and posted, resulting in straight-through processing. Less human involvement means fewer human errors.
In years leading up to the development of online trading, futures brokerage firms increasingly abandoned the personal trader (often referred to as the retail customer), due to small order size and broker liability. Brokerage firms could have tolerated the small order size, but the liability created by the brokers interfacing with personal traders became untenable. Misstatements by brokers and the outright fraud of unauthorized trading and churning subjected the firms to enormous legal expense, reparations and even regulatory sanctions. During the 1980s and ‘90s several brokerage firms were dealt a death knell in the aftermath of broker misconduct. Online trading virtually replaced the broker and eliminated much of the potential danger and unpredictable cost.
The combination of electronic order handling efficiency and the near elimination of broker liability enabled firms to lower transaction costs to customers. The personal trader who paid $50 to $75 per round turn futures transaction a decade and a half ago pays less than $20 today, and those costs continue to decline.
It can be argued, successfully in most circles, that the best thing for both customers and their brokers is online trading. So, why are the purveyors of futures contracts — futures exchanges – slower than they might be to fully embrace electronic trading? Good old-fashioned greed! Of course, pit politics play a part too, though the electronic writing is on the wall. When faced with the inevitable, exchanges will often begin to go with the flow.
There are two important issues when considering the customer benefits of online trading — parity of market interface and transaction costs. Trading parity, or the leveling of the playing field, is trader empowerment that should be considered a basic customer right. It is hard to justify giving one class of investor an advantage over another, but that’s the way it is at futures exchanges that offer primarily pit-traded markets. A privileged few traders actually standing in the trading pits see real time price quotes and who is trading what. They also receive immediate notification when an order is executed. Anyone not standing in the trading pit has less access — sometimes substantially less.
In “fast market” situations, any trader not standing directly in the trading pit is even more disadvantaged, (by definition a “fast” market is when prices are changing so quickly that the price reporting clerk is unable to enter all of the price changes). When fast market rules come into effect, customers may be limited to the type of conditional orders they can place, and the trading pit will not be “held” to a particular rule on order filling or price. Unquestionably, one of the worst things a futures broker can say to futures traders is that the orders they’ve placed will not necessarily be handled based on the rules the futures customer understood to be true. In online trading, there are no fast market conditions because the trading matching engine is also the price reporting facility. This is a relief for market participants.
The Exchanges are Changing, But Fast Enough?
The introduction of electronic trading platforms for futures exchanges was perhaps the single-most forward-thinking innovation since financial futures were introduced in the 1970s. It’s likely that futures exchanges did not make the decision to walk down the electronic path by themselves. Instead, perhaps they were led into the decision to innovate electronically as growth of day trading in equities exploded. They wanted a piece of the action. Clearly, futures, despite superb product innovation and sharply increasing volume, was still step-sister to the equities business in terms of customer interest. What better way to step up business than to make it easier? Powerful new hardware and software and an emerging new Internet generation made it all the more appealing.
However, there were still the pits and, as mentioned earlier, they weren’t going to disappear at the drop of a hat. So, electronic trading became an after-hours scenario, limited to certain products. ETH (electronic trading hours) and RTH (regular trading hours) became the terms that were thrown around.
When the Chicago Mercantile Exchange stepped out of the after-hours scenario with the fully-electronic smaller version of the S&P 500, the world changed. Some questioned if it would take root, if the concept would be embraced. And, of course, competition was the impetus. The Chicago Board of Trade had won rights to offer the Dow futures product for trading, and the Merc had to come up with something new. The E-Mini S&P 500 was the answer. This changed the landscape of electronics for futures exchanges forever.
But, if that concept of a full electronically traded futures contract does work, and work well, why not make the conversion totally? The exchanges have decided to let the customers decide which system they want to use in many cases, pit or electronic. The financials seemed like a natural, but even today, agricultural futures traders have the choice of whether to place an order in the pit or on the e-platform. Even pigs are on the platform.
Interestingly, however, even when given the golden opportunity to go fully electronic seamlessly in certain product areas, some exchanges have opted out. The Chicago Board of Trade, who owned the MidAmerica Commodity Exchange, could easily have converted the MidAm’s mini-contracts to an electronic platform when they closed this little exchange. It would have been so simple. Instead, they are offering MidAm contracts both in the pit and electronically – letting the customer decide.
Some exchanges are more progressive than others, allowing electronic and pit to trade side-by-side, while others cling to the open outcry pit system during regular trading hours and then electronic after the boys leave the pits.
As the completely electronic Eurex heads toward America’s shores, one suspects that the list of products listed on electronic platforms will increase. If not, there may be a price to pay.
Nothing is Free
Understanding the impact of clearing and exchange fees charged on futures transactions is not as simple as one might expect. Exchanges are proud to claim that based on the “notional value” of the futures contract their fees are extremely low, and that is unquestionably true. Notional value refers to the full value of the futures contract, e.g., the notional value of the S&P 500 futures contract is the current price 866.80 times 250 = $216,700.00 (as of April 9, 2003). For anyone using the futures market for hedging or forward pricing, the futures market definitely offers the lowest price solution. Clearing and exchange fees do not significantly impact their cost of doing business; bundled fees as a percent of notional value are only 0.0021 percent. For institutions using Eurodollar futures, the impact of fees is even less, only 0.0003 percent of notional value.
It is widely known that only a small percentage of futures market transactions are conducted by bona fide hedgers. For most other futures traders, the notional value of a futures contract is nearly meaningless. But return on investment means a great deal to most investors, so they need to look at the amount of money needed to trade in various markets. For futures contracts, the amount of initial “investment” is the margin required. Most traders need to know how much of a bite fees will take for every $1,000 they “invest.” From this perspective one of the most expensive futures contracts to trade is the Eurodollar — $3.28 per $1,000 invested goes to clearing and exchange fees. That’s over 12 times as much as the impact of fees on $1,000 invested in the S&P 500.
Using the fees-per-$1,000 criteria, it is obvious which exchanges are favoring investors with their fee structures and which may be taking advantage of customers. One of the most customer-friendly fee structures is the fee Eurex charges its customers for DAX Stock Index transactions – only $0.11 per $1,000 is charged. Of course, Eurex is a totally electronic exchange and, therefore, does need to subsidize the infrastructure of trading pits with its electronic transaction activity.
When comparing fees for CME’s E-mini S&P 500 with the fees for Eurex’s DAX, it becomes apparent that either the CME is subsidizing its pit-traded business with its electronic traded business or is choosing to take advantage of the kinds of profits this very active contract can ring up.
Even purely electronic exchanges are not giving the full benefit of electronic transactions to customers. Why should a customer trading 100 futures contracts pay the same clearing and exchange fees per $1,000 invested as a customer trading a one-lot? The fees per $1,000 are the same at all exchanges whether the customer trades one contract or 1,000. This is a situation that needs some fixing.
There are many issues that are not new, and current clearing and trading fee structures seem designed more for the benefit of shareholders than for customers.
Top Ten Features to Look for In an Online System
The exchanges will make changes when competition forces them to do so. Until then, traders are still better off than in the old days when pits were the only game in town. In the meantime, traders gearing up must look to the side of the coin they can control, and that includes the best features of an online system.
When surveyed, most traders will put speed, reliability and simplicity or user friendliness ahead of transaction costs. Here are the top ten qualities for which to look:
1. Simplicity. If it isn’t simple, it isn’t good. A major goal for creating an online platform should be to make complicated and time-consuming procedures simple. Use the rule – If you have to use the keyboard to enter an order, then the system is not simple enough. The simpler a system is the less likely you are to make errors.
2. Speed. This goes along with simplicity. It is not enough to consider transmission times for your calculation of the speed of a system. The ease of entering an order translates to speed. What good is a millisecond transmission time if it takes five minutes to compose and enter an order?
3. Reliability. With computer technology there is no such thing as an infallible system, particularly when you consider that all online systems must rely on some form of telephone connection. Look for systems with technical redundancy – not just parallel redundancy, but redundancy using different geographical locations. Above all, don’t rely on any system to be totally reliable. Look for systems that are backed up with voice communications with real, live humans providing technical support and customer service.
4. Security. Look for an online system that encrypts transmissions. We’re talking about real money here — your money! Don’t trust your financial information to float naked into cyberspace. Encryption and security codes are a must. Also find out if the system’s server is firewall protected, because you don’t want hackers wandering through your financial records.
5. Risk management. The best systems have a risk management function that checks the incoming order against your current account equity. Sure, this feature is designed to protect the brokerage firm from a customer establishing positions beyond their financial wherewithal, but it also protects you. A good risk management system will help prevent the accidental placement of an order with the wrong quantity, or a buy order instead of a sell order. It won’t read your mind and correct what you “said” with what you “meant,” but it will protect you from a catastrophic error, an error beyond your means.
6. Backup. This goes hand-in-hand with reliability, or the inevitable occasional loss of reliability. Backing up an online system comes in many forms. The system’s back-up function must be able to restore any trading records and customer account information in the event of an outage — that’s a bare minimum. The best technologies are also backed up with non-technology – real human beings. Inevitably you will need to talk to someone, whether you need an answer to a technical question, or your computer just “blue screened” and you need to place your orders the old-fashioned way with an order desk.
7. Real-time accounting. The system should be able to tell you, on a real-time basis the impact of your current positions on your account equity – in other words, your account status on a real-time basis. You should be able to receive your daily account statement online via the same system, and the best systems enable you to retrieve archives of your previous statement through the same procedure. Additional useful features include the ability to examine your day’s trading, trade by trade, and to analyze your trading with reports.
8. Real-time price quotes. Some price quotes are allowed to be distributed free of charge to customers, e.g. E-mini S&P 500 (CME) and E-mini Dow Index (CBOT). Your online system should deliver streaming quotes on these markets. The best systems will also deliver a portion of the “book” on these markets, the price quotes and volumes of orders above and below the current price. You should be able to retrieve delayed quotes from all markets that cannot be supplied real-time, e.g. U.S. T-Notes, soybeans, cattle, etc. If your online system is providing real-time quotes on markets that require payment for quotes –BEWARE. Violation of this exchange rule can result in severe penalties.
9. Favorable commission rates. Due to the efficiency of online trading and straight through processing (posting and accounting), the economics for the brokerage firm are improved. Your broker should be willing to pass these savings on to you. Be careful, though, of super discounted rates. Good technology is expensive to develop and maintain. A great rate won’t help you when you need customer support or technical assistance.
10. Simplicity. Yes, again, first, last and foremost the keyword for online systems should be simplicity. The simpler the system, the safer, more reliable, faster and easier to learn it will be.
Amen
The electronic trading revolution has brought about the disappearance of traditional models and loyalties in the securities business, in options in particular. Futures are now on the cusp of vaulting into that revolution. It’s a tough choice for many of the exchanges that until now have been the masters of their own destinies and of their customers destinies as well. They could go electronic or create a hybrid model. They could stick with the pit. But customers are demanding equal treatment as well they should. Electronic trading opens up new customer avenues, and there must always be an eye to how well customers are treated. The orders from the public is what feeds the market. One must never forget that.