Michael looks at the various types of stockbrokers in this article and how they can be used effectively.
Having the right stockbroker can have a huge impact on your P&L.
It came as no surprise to me that Shares decided to close down its UK operations.
You most likely haven’t heard of this broker – the reason being it never got off the ground properly. I was invited to the launch party in December 2021 and the goal of this broker was to build a ‘community’. This was off the back of the meme stocks saga where WallStreetBets was in the news regularly.
The problem was that this was just a fad, not a structural change in trading. Most of these traders are no longer trading, and a lot of these traders were gambling with smaller amounts.
I’m all for traders getting started small as it makes sense to lose a little money rather than steam into the market, however, a business model based on traders with small amounts (and charging extortionate fees) needs a lot of volume. And the problem with gamblers is that they often blow their money and don’t come back.
This business model works fine of course for brokers that run a B-Book.
A B-Book is where a broker doesn’t hedge its trades because it knows that most traders will lose money within the first few months. Therefore, if it just takes the other side of the trade, then all of the punters’ losses end up as broker profits.
This isn’t the type of broker you want to be signed up to. A broker that has an active interest in its clients losing money isn’t great. Plus, these brokers are enablers to the affiliate scams we see with their rented Lamborghinis. By promising a false lifestyle of working 10 minutes a day and making millions, these individuals lure in both suckers and desperate people looking to make a few quid quickly and earn handsome affiliate fees for every broker introduction. I was once offered $30,000 to work and be the face of a broker in a faraway land because they knew that they would make a lot more if I was to introduce losing clients to them.
But as mentioned, when it comes to trading stocks, selecting the right stockbroker is crucial. Sometimes you need more than one for your trading.
It’s likely you’ll want an execution-only (XO) broker as these brokers are competitive on fees and allow you to deal yourself.
For active traders (and even investors) you’ll want a full range of orders available to you and that means having access to both Direct Market Access (DMA) and the RSP (Retail Service Provider). I use IG Markets for this and L2 Dealer.
The Importance of Direct Market Access (DMA)
Direct Market Access (DMA) is essential for active traders. DMA allows traders to place orders directly on the order books of exchanges, bypassing intermediaries like market makers. This direct interaction with the market provides several advantages:
Firstly, orders are executed faster. This is because you’re directly on the order book rather than waiting for a broker to finish his coffee and chat with his mates, before seeing which price levels have been triggered.
Secondly, you can see real-time market data including the full order book, which aids in placing more effective orders. For example, if you can see a large order on the bid and you’re looking to buy, you want to be ahead of that order so it can act as a cushion for sellers underneath you. Going underneath that order means the large order gets filled as a priority ahead of you!
And finally, the most important: By placing orders directly on the exchange, you can often get better prices compared to using a market maker. This is because with DMA you become the market maker, telling the market you’re happy to do business at a certain price and size. This means you can bid to buy, and go on the ask to sell, rather than paying the market maker’s prices.
Market Maker Quotes
The other form of dealing (and most XO brokers offer this) are through market makers. Market makers are entities that provide liquidity to the markets by being ready to buy and sell securities at any time. They quote both a buy price and a sell price, ensuring that there is always a market for the securities they cover. While market makers provide liquidity and stability their quotes always come with a spread. This is the difference between the buy and sell price.
For less liquid stocks, particularly those listed on AIM (Alternative Investment Market), market makers play a crucial role. AIM stocks can be highly volatile and less regulated, making them riskier but potentially more rewarding. As the stock’s liquidity thins, the spread widens. Illiquidity works both ways. When there is a scramble for stock it can drive it higher but also it can be a crowded exit.
You also need to be aware of the Exchange Market Size.
Due to the European Securities and Markets Authority regulation put in place in 2018, under the ‘best execution’ laws your trade won’t be filled if you’re within the Exchange Market Size and the market makers are offering you a price outside of the spread.
This rule is designed to ensure market participants get the best prices. In reality, it means in a crashing market you might not be able to sell those who are holding amounts larger than the Exchange Market Size can. This is because these rules are created by people who don’t know how the market works or bother to consult someone who does, and so private investors have even more odds stacked against them as a result. In effect, the best execution regulation does the exact opposite of what it was intended to do.
There are also stockbrokers who offer access to equity placings, which is perhaps the topic of a future article.
Michael Taylor
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Twitter: @shiftingshares
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