by Larry Swing - September 19 2005

Education

You pay brokerage commissions and expect quality service in return.

Think again.

Your brokerage is not designed to make money for you.  It is designed to make money itself.

Do not trust your broker or your brokerage.

Here are a few major brokerage sins:

1. Selling order flow
2. Internalizing trades
3. Data mining trade information
4. Encouraging churning

In addition to these major sins, brokers sometimes make more overtly harmful actions:

5. Encourage unsuitable investments
6. Misrepresentation
7. Unauthorized trading

1.  Selling Order Flow

This practice entails selling customer market orders to external firms that may then transact against it.  Transactions are generally executed at the national best bid or offer (NBBO).

However, the NBBO might not be the best available price.

It is relatively common for trades that are executed in the NYSE to receive price improvement from the specialist (who steps in front of limit orders to do so).  If the stock is transacted through INET, it could hit a hidden order that would provide a superior price.

Furthermore, your broker's practice of selling order flow reduces competition for market orders; the reduced competition leads to larger bid-ask spreads and decreases the depth of the market.  As a result of brokers selling order flow, the markets are less efficient.

2.  Internalizing Trades

This is very similar to selling order flow.  Instead of receiving payment for allowing others to execute against their market orders, the broker will execute against it themselves.  The result is the same as for selling order flow.

3.  Data Mining Trade Information

Brokers may data mine your historical trading information to determine patterns in your activity.  They may then trade based on this information.  Here's a simple example of how this can hurt you:

Step one:  You make many trades.  Generally, you scale into and out of positions, and trade several hundred shares at a time.

Step two:  Your broker data mines your trades.  They find that if you make a first buy (sell) in a stock, you have a 90% probability of making a subsequent buy (sell) in the same stock within five minutes.  They find that your transactions are large enough to move the stock in the direction that you are trading.

Step three:  You place a trade to buy 500 shares of an illiquid stock, and are executed at 12.53

Step four:  Your brokerage places a trade to buy 500 shares of the same stock, and they are executed at 12.55.

Step five:  You place another trade to buy 500 shares.  You are executed at 12.58.

Since your brokerage traded in front of your second order, the execution price for your second trade was worsened (by three cents, in this example).

4. Churning

Some brokers will contact their clients with new analyst reports, or recommendations.  The broker may want to help your portfolio grow, but just as likely they are trying to encourage you to trade for the sake of commissions.  It may not be in your best interest to always do what they say.

Other brokerages may ask to have discretion in trading your account, and then churn it to generate commissions.

Analyses of ETFs

BBH:  Neutral.  (Biotechnology)

BDH:  Neutral.  (Broadband)

BHH:  Neutral.  (Business to Business)

EKH:  Neutral.  (European Stocks)

HHH:  Neutral.  (Internet)

IAH:  Neutral.  (Internet Architecture)

IIH:   Neutral.  (Internet Infrastructure)

OIH:  Bullish.  (Oil Services)

SwingTracker
MrSwings Real-Time Stock Charts RISK-FREE TRIAL featuring one-click access to Larry Swing's profit-generating indicators - Force Index, EquiVolume, True Strength Index

PPH:  Neutral.  (Pharmaceuticals)

RKH:  Neutral.  (Regional Banks)

RTH:  Neutral.  (Retail)

SMH:  Neutral.  (Semiconductors)

SWH:  Neutral.  (Software)

TTH:  Neutral.  (Telecommunications)

UTH:  Neutral.  (Utilities)

WMH:  Neutral.  (Wireless)

Individual Stocks

HPQ