Online Trading: How To Make Money The Newfangled Way

When Abner Oldham launched his financial-planning practice in 1992 after nearly 20 years as a broker for E.F. Hutton and Dean Witter, he chose not to route stock trades back through his old firm. Instead, the Chattanooga adviser zaps them via computer to one of three electronic brokerages that offer dirt-cheap commissions and prompt executions. "I usually get my trade confirmed in less than 15 seconds," says Oldham, who uses PC Financial Network, Pacific Brokerage, and Charles Schwab's StreetSmart. "One thing I will not repeat is going back to the full-service arena again."

Thanks to the computing revolution, investors can tap into a growing number of online brokerage services that plug customers into the floors of the major stock exchanges. With fee schedules that begin as low as $15 per trade, these cyberbrokers could hold a certain appeal to anyone tired of shelling out hundreds or even thousands of dollars a year in commissions. But are these electronic discounters as much a bargain as they seem to be?

LOW COSTS. For the most part, the answer is yes--although they're not for everyone. Online brokerages are best suited for savvy investors who don't need hand-holding. And in their quest to keep overhead low, a number of online operations offer a narrower range of products than their full-service rivals and can be quicker than the big firms to nick you with hidden fees for everything from closing an account to requesting a stock certificate. There's also evidence that investors don't always get as good a price when buying or selling securities as can be obtained through other channels.

For some, those may be acceptable trade-offs for commissions that are a fraction of those charged by full-service firms such as Merrill Lynch and are even below traditional discounters such as Charles Schwab. How do they do it? The online services--some of which happen to be offered by Schwab, Muriel Siebert (800 872-0711), and other discounters--say their reliance on computers reduces labor costs and eliminates most order-entry mistakes, which are expensive to untangle. They also say the Internet has slashed their communications costs, allowing them to pass on the savings.

PRECAUTIONS. Of the two dozen brokerages that offer online trading, about a half-dozen are open for business on the Internet--with more on the way. (Such trading, of course, requires a separate Net account, which can cost an extra $5 to $25 a month.) Settlements are done the old-fashioned way, by check.

Given public concern over security breaches on the Net, most of the leading Internet-based brokers--including E*Trade and K. Aufhauser--only provide access to their Web site via Netscape Navigator 2.0, the Web browser that's believed to have the most sophisticated encryption precautions. To prevent hackers from wreaking havoc, none of the Internet brokers allows customers to change an address, withdraw money, or liquidate an account except in writing or in person.

Along with security concerns, cyberbrokers have been battling a perception that they don't always get customers as good a price as full-service brokers, especially on small, thinly traded stocks. The reason is that the online brokers, just like many conventional discounters, accept what's known as "payment for order flow"--meaning that they have contracted to steer customer trades toward a specified market maker willing to pay a few pennies per share for NASDAQ stocks and even some New York Stock Exchange-listed securities.

Those pennies can add up: For a typical order of 1,000 shares, the market maker might fork over $20. Critics say this lessens the chance that customers can get their trades executed between the posted "bid-ask" spread--the difference between what Wall Street's middlemen are willing to buy and sell a stock for.

LIMITED LINE. Most cyberdiscounters openly acknowledge accepting payment for order flow, although they argue that it helps subsidize their cut-rate commissions. Without it, "everyone would have to raise their commissions," says Bill Porter, founder of E*Trade Securities. And some impartial experts believe the effects are overstated: University of Michigan economist Charles M.C. Lee says the price discrepancies may occur only on every 10th trade and cost customers just an extra 12 1/2 cents to 25 cents per share--still leaving cyberbrokers with a huge price advantage. "If investors are content to get the published spread, then these services are a boon to them," says Robert Wood, a finance professor at the University of Memphis.

On price, the hands-down winner is E*Trade, which offers to trade up to 5,000 shares of any NYSE- or American Stock Exchange-listed stock for $15, and any NASDAQ stock for $20. But E*Trade's product line is more limited than rivals such as Accutrade, Schwab, and Fidelity's On-Line Xpress service (800 544-8666). E*Trade handles stocks, bonds, and options and provides limited check-writing. However, E*Trade doesn't offer futures trading, many no-load mutual funds, or annuities and certificates of deposit.

To its credit, E*Trade does accept short sales via computer--even though those trades often must be processed manually. What's more, E*Trade also handles most complicated trades, such as "versus purchase" orders that allow investors to specify which lots are being sold to limit their tax liability. By contrast, a survey by the American Association of Individual Investors in January revealed that some cyberbrokers--including Jack White (800 233-3411) and National Discount Brokers--don't permit selling short by computer and don't handle "versus purchase" orders.

For the active trader, Aufhauser may offer an irresistible deal: For an $800 annual fee, it allows unlimited trading as well as delayed price quotes (real-time quotes cost an additional $20 a month). The catch: All trades must be made on Aufhauser's Web site in 100-share denominations and--as is the case with the new e.schwab service--all account queries must be made via E-mail rather than by phone. What is more, Aufhauser imposes some of the steepest service fees, such as $50 to close an account and $20 for wire transfers.

BASKET CALL. But the most sophisticated services may come from Accutrade. The Omaha-based brokerage has written software that lets its customers enter account data into a $575 handheld device and then get price updates or place trade orders by plugging it into a phone. And Accutrade's new Windows-based software allows users to construct "program trades" that are triggered under scenarios they create. For instance, traders can assemble a basket of semiconductor stocks. Then they can instruct the software to provide price updates every hour and automatically sell the basket if, say, Intel drops 5%.

Who could have guessed a decade ago that investors would have access to such advanced trading tools? Some futurists predict the advent of electronic matching services that let small investors buy and sell stocks on the Internet for a small transaction charge--but without the spreads Wall Street traders pocket for themselves. If so, that could spell a dim future for brokers--and a bright one for computerized trading.

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