Dealing Costs and Direct Market Access Contracts for Difference Trading

MoneyAM Shares Magazine

Cost is clearly an important consideration when choosing an online broker but investors need to weigh up all aspects of the service before reaching a decision. When evaluating the different options it is important to keep in mind the likely frequency and size of the trades since this will have a direct bearing on which company will represent the best value.

Some online brokers do not levy an annual or management fee but the majority of firms make a fixed rate charge of around £20 to £40 a year. Others calculate the cost according to the number of different shares held and the overall portfolio value. Clearly investors with larger accounts would find it better value to opt for a provider offering a fixed or capped charge. Another point worth checking is that some firms waive their fee whenever there is a trade in the quarter, or more rarely impose an inactivity fee of around £10 when an account holder doesn't make a single trade in a given period.

Some clients of phone-based brokers have
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Those who trade relatively frequently will find that the dealing charges are far more significant than the annual account costs. The cheapest commission rates start at around £9 or £10 for trades worth up to £2,000 or so. A large number of online brokers charge £12.50, with the less competitive being up around the £20 to £25 level. Often rates are tiered with larger trades costing slightly more.

Some brokers offer incentives to encourage new clients, such as free or heavily discounted rates of commission during the first month. For active traders the most valuable concessions are the frequent trader discounts which many firms offer as a way to encourage this type of client on to their books. The definition of just what constitutes a frequent trader varies between brokers but for the most part trading at least ten times a quarter will entitle the investor to a few pounds off the normal commission charge. This can add up to a substantial saving over the course of a year. The biggest cost of trading, especially when dealing in smaller stocks, is normally the bidoffer spread and this is also usually the hardest to quantify. Many online share trading platforms actually incorporate technology to minimise the spread by looking to beat the best (yellow strip) price displayed by the London Stock Exchange. The way this works is that stockbrokers act as middlemen between the investors and the market makers, also known as Retail Service Providers or RSPs. At any given time different RSPs can and do offer different prices for the same shares. What the technology does is to scan multiple RSPs to automatically find the best available price at that time. This summer for example the typical average saving per trade made at the top brokers was around £7 or £8.

The vast majority of online stockbrokers do not provide credit facilities so investors looking to buy shares will need to deposit the necessary funds in their account. Those who want to make their capital stretch further by trading on margin will usually do so by trading CFDs or by spread betting.

In many respects trading equity CFDs is very similar to normal share dealing but unlike share traders who have to pay the full value of their positions, a CFD only requires a deposit or margin balance, which for blue chip stocks may be as little as 10%. For example, a deposit of £1,000 would be all that is required to take an equivalent position of £10,000 in the underlying equities. With CFDs there is a daily financing charge typically calculated at 1.5% to 2.5% over base rates and the commission for the trade will be around 0.20% (£20 in this example) but with no stamp duty to pay.

Spread betting too is available on margin of 10% and it is also free of stamp duty. In fact the only cost is the spread itself and betting on a FTSE100 blue chip stock will typically cost 0.3%. This figure incorporates the financing charge since spread bets, unlike CFDs, have a fixed life of typically three months. What the two have in common is the ability to go both long and short so as to benefit from price falls as easily as price gains.

Information resources

One of the most convenient aspects of using an online broker - quite apart from the ease of actually trading - is having all the necessary information to hand to monitor the current holdings and research new opportunities. All a client has to do is to log in to his provider's website to see the current or in some cases 15-minute delayed share prices together with the performance of the various national and international market indices and reports summarising the day's key events.

News flow is critical to prices and most brokers provide a complimentary news feed with RNS and/or AFX announcements, such as Dow Jones Newswires. This covers items like official company announcements together with broker upgrades, directors' deals and relevant press stories as they happen. As well as the current breaking news stories most of the websites also allow people to search for all the historical announcements relating to a particular company of interest.

The majority of online brokers provide clients with free access to fundamental data and other useful information to enable them to research potential opportunities. This material will very often include consensus analyst forecasts, details of directors' dealings, a round up of the share tips in the press and even in some cases professional research reports and recommendations.

Anyone who has ever traded online will be familiar with the basic Level 1 data, which shows the best yellow strip price from the LSE together with the associated available volume. It is now however becoming increasingly common for brokers to make available the full electronic order book. This so-called Level 2 data shows all the current bids and offers for a particular stock with their associated volumes.

Seeing the full market depth data like this can provide the final piece of the jigsaw when trading, helping investors to assess the price offered by their broker if dealing immediately, or otherwise suggesting where to pitch their limit orders so as to get the best price possible. Active share traders and CFD account holders who tend to make at least 15 round trip trades a month will usually be entitled to receive this information free, but less frequent traders will normally have to pay a monthly charge of around £30-£50.

Direct market access to order books

Arguably the best way to exploit the power of the Level 2 screen is to sign up with one of the companies offering online direct market access CFD trading. Clients can use this technology to enter orders directly on to the LSE's electronic order book. Whenever they enter an equity CFD ticket the provider will automatically create the equivalently priced order in the underlying share and it is this 'shadow' instruction that appears on the order book.

Direct market access or DMA traders can either deal immediately at the true bid and offer or they can enter an order within the spread to actually improve on the market price. If a share were trading at 150-151 in the underlying cash market then someone using a quote-driven CFD service would have to pay the full offer of 151. A trader with access to DMA could, for example, put an order on the bid at say 150.5 so that he becomes the best bidder in the market with a good chance of getting a favourable fill.

Even in a liquid market there are times when the spread can widen and anyone with access to DMA has the scope to take advantage of this. With a share quoted at 200-210 a DMA trader could put on a bid at 202 and an offer at 208, both being on the yellow touch strip. If each of these orders gets filled then the result would be a 6p risk-free profit from the spread, while if only one side goes through it would still represent an improvement on the market price. The instantaneous order execution available with DMA also makes it feasible to trade breaking news, since those who are watching the screen and quick enough to respond stand a good chance of getting their orders filled before the market has fully digested the new information.

Another advantage of DMA is that it is the only way that private traders can enter orders directly during the opening and closing auctions on the London Stock Exchange. There are currently more than 650 UK stocks that start every trading day with a pre-market auction between 7.50am and 8.00am and end it with a post-market auction from 4.30pm to 4.35pm. From a trading perspective, the auction is very often the time when a stock records its high or low of the day, and it is only by actively taking part that the best prices and hence the biggest possible moves become available. Direct market access CFD providers typically charge a headline commission rate in the order of 20 or 25 basis points although active traders will normally be able to negotiate more favourable terms.

Frequent trader platforms

Active traders have different dealing and data requirements to longer-term investors and some stockbrokers have created sophisticated trading platforms designed specifically for them. Clients may have to pay a monthly subscription fee to access these additional features or they may be entitled to receive them free as long as they place a certain minimum number of trades in the period.

Being constructed with the active trader in mind these platforms will invariably provide live streaming Level 2 stock prices showing the actual bid and offer updating in real-time without the need to refresh the screen. Watchlists of target stocks can be created to show live updating prices, while existing portfolio holdings are also valued in real-time so that they remain fully up to date. Screens can generally be customised to simultaneously display all the stocks, markets and news of interest with one-click fast dealing to capitalize on the opportunities as soon as they arise. This type of sophisticated information and dealing functionality is much more widely available when spread betting or trading CFDs, FX, or futures and options. Some companies provide multi-product platforms that support all of these instruments. It is absolutely crucial to have real-time streaming prices and news when dealing with margined products such as these, as even relatively small price movements can lead to large profits and losses. Managing the cash is also critical since sufficient margin must be maintained at all times to avoid the risk of positions being closed out prematurely. Often these platforms are free for account holders although in some cases there will be a charge for the Level 2 data and possibly exchange fees as well.

Tools for active traders

Online brokers provide some particularly useful web-based functionality for spotting trading opportunities. Stock screeners for example are helpful in identifying shares that meet certain specified criteria. These normally enable people to search on the basis of financial measures such as PE ratios and dividend yields, as well as other important indicators such as the recent share price performance. Many brokers also provide lists of the top daily movers. Intraday traders can use these to quickly pick out momentum opportunities such as the biggest risers and fallers for the day as well as those shares with the highest trading volume.

One of the most popular ways for active traders to spot opportunities is by using technical analysis. Many traders avidly study the price charts for evidence of support and resistance, trends and breakouts, basing their trades on these well-known patterns. In view of this a number of companies provide clients with daily or weekly technical summaries of the markets picking out the key levels and giving some guidance as to what to look out for.

Online stockbrokers typically offer a basic charting capability that allows clients to look at the price charts for selected shares, but very often there will be little scope to customise the display. CFD and spread betting providers on the other hand usually go much further and incorporate in-built charting software into their websites. Traders can use this functionality to create historical or intra-day price charts in different formats such as line, bar and candlestick. There is also the ability to add volume data as well as customizable indicators including favourites such as moving averages, MACD and RSI. The really sophisticated platforms even allow traders to create and backtest their own indicators to gauge their effectiveness.

Summary - Direct Market Access CFD Trading (DMA)

The trade execution process for instruments such as futures and options contracts and direct market access CFDs is immediate - almost instantaneous in fact. Where speed and transparency are potentially more of an issue is when spread betting or using a quote-driven CFD service, since the broker is also fulfilling the role of the market maker. Clients need to be confident that the spread betting and CFD prices will track the underlying securities without any delay or intervention by the dealer. Providers are well aware that they need to be able to justify their quotes, which is why most calculate them automatically from the price of the underlying security while also hedging each client trade so as to remove any potential conflict of interest. In practice the only real concern over possible dealing delays is when trading in large volume in an illiquid or difficult to hedge product. Whatever the instrument, trading via the internet is invariably faster than over the telephone as there is no delay while the dealer quotes the price and checks the account details.

Brought to you in association with MoneyAm Shares Magazine