Choosing An Options-Friendly Brokerage Firm: Several Criteria Are Important, And One Is Critical

The Trap

For many investors, there has been a sea change in how their accounts operate. Once we had Joe, our personal broker who called us with trade suggestions, remembered our birthday, and if we had a large account, invited us to lunch occasionally.

Today many, if not most, of us take advantage of the extraordinary power of online investing. No more waiting for our broker to get back from lunch before we can place an order. Now we have instant information, analyses, charts, order placement, and our account status at our fingertips with a mouse click.

While this is clearly a more efficient method for gathering information, placing orders, managing our trades, and reducing transaction (commission) costs, the migration to online investing has also laid a trap for the options investor.

Too often they decide on where to house their option accounts on the basis of whom they use for their stock trades and/or which company offers the lowest commission on options.

Falling into the convenience or consider-commission-only trap can slice your Rate of Return in half!

What Makes A Brokerage firm “Options-Friendly?”

These are the criteria, listed in order of importance, that I believe make a brokerage “options-friendly.” And let’s be clear, if your brokerage is not options-friendly, it is almost certainly costing you money.

  • Favorable margin policy (CRITICAL)
  • Competitively low commissions
  • Online Trading Platform – should offer user-friendliness for order entry, no cost live price and news data, in-depth analytical resources, trade training courses, and account status information.
  • Options-Knowledgeable People – You must be able to quickly reach a human options specialist to place a trade by phone, or have a question answered or a problem resolved.
  • Prompt Reply to Emails or Phone Calls – Firms vary greatly on this one.
  • Identical commission rate for telephone or online orders.
  • Absence of “inactivity fees.”
  • Practice Accounts – to familiarize you with the online platform, and for practice trades without risking actual money.

The Top Two Criteria For Brokerage Firm Consideration By Option Investors

1. Margin policy re: Iron Condors

This puppy is definitely critical if you are an investor seeking a monthly stream of income via option credit spreads.

Specifically, the issue is how the brokerage firm handles margin requirements with respect to the Iron Condor – a type of option trade that supercharges your rate of return without increasing your risk. The Iron Condor involves placing both a Bear Call Spread and a Bull Put Spread on the same underlying index, stock, or ETF. Both spreads can provide the investor with a premium (income).

Thus, there are two credit spreads involved in the trade, one with strike prices placed above the current market, and the other with strike prices well below the current market.

As with all credit spreads, the objective is to establish spreads far enough away from the current market as to make it unlikely that spread will be in-the-money at option expiration day. When the options expire worthless (out-of-the-money), the investor keeps the entire initial premium he earned when placing the spreads.

An options un-friendly brokerage demands that you employ margin for both spreads involved in the Iron Condor trade.

An options-friendly brokerage, on the other hand, recognizes the fact that it’s absolutely impossible for both spreads to wind up in-the-money on options expiration day. (That’s basic physics; you can’t be in two places at the same time.) Accordingly, at an options-friendly firm you only need to have margin coverage for one side of the trade.

Why is this critical? Because if the firm requires two margins, it cuts your rate of return, i.e. your return on margin investment, in half!

Therefore, if the brokerage firm requires margin on both sides of the trade, it makes sense to immediately disqualify it from consideration as your options broker. I would not even bother to see how such a firm qualifies on the rest of the criteria on the list.

2. Commissions

You should not have to pay more than $2.00/option, and you should be offered a lower rate if you typically trade multiple contracts.

Also, if they hit you with an “inactivity fee” if you are not trading enough to suit them, you have good reason to scratch that brokerage off your list.

Trading Platform

Nowadays, most major brokerages have excellent online trading platforms and support facilities. The problem arises if they charge extra for real-time quotes, charts, or other resources you would expect be covered by the commission you pay, rather than being a costly add-on.

Does Size Matter?

In the matter of options – particularly option credit spreads established for monthly income – the answer is “not really.”

Perhaps surprisingly, several very well-respected major firms whose stellar reputations are well deserved in a general sense, are decidedly unfriendly when it comes to their option clients.

Investigating First Is Time Well Spent

The bottom line metric for your investments is your rate of return. While your trade selection is obviously a very important factor in determining your success, your necessary “partner” in the undertaking is the brokerage firm you select.

For this reason, if options – especially credit spreads – are or will be a significant element of your investment activity, take the time to check out your current or prospective brokerage options policies and facilities before opening your account.

If you are able to read (you obviously are since you are reading this!), or can use email or a telephone, you can easily determine if the firm you are considering for your option investments is options-friendly or not.

You can also review published reports that rank brokerage firms in terms of the various considerations of option-friendliness described above..

Best Brokerage Firms

Based in Morris County, New Jersey, The Daily Record reviews the best brokerage firms around the brokerage world. It quotes Smart Money Magazine’s latest survey which placed Fidelity as “Premium Broker”, TradeKing as “Best Discount Broker”, and Merrill Lynch as “Best Full-Service Broker”.

Yet, the Daily Record newsroom, headed by Warren Boroson, responded that the survey of these three best brokerage firms may not be sufficient enough for brokerage trackers since it is not suitable for day-traders or those who buy only mutual funds. Accordingly, Smart Money’s survey and rankings are based only on buy-and-hold customers who are into stocks, bonds and mutual funds, those with a $50,000 account, and those who want to write covered calls.

Nevertheless, the ranking of the best brokerage firms by Smart Money has still been based according to set quantifiable and qualitative criteria. To determine the best brokerage firms, Smart Money sent their reliable field reporters to open brokerage accounts in 14 potential brokerage firms. The reporters bought and sold different kinds of securities, questioned the firms’ customer service through phone and e-mail, checked their account statements and tax forms, and reviewed scrutiny on the web sites, as among some of the survey’s conducted measures.

To note, the Smart Money study also included supplementary standards to further determine the best brokerage firms more accurately or to come up with the best possible approximation through their available means. They included the brokerage firms’ size of commission, investment products, banking amenities, trading tools, level of research, and customer service.

And the results – Fidelity, TradeKing, and Merrill Lynch as the three #1’s. Next to Fidelity in the honor as “Premium Broker” are E*Trade, Charles Schwab, Banc of America Investment Services, TD Ameritrade, WellsTrade, and Vanguard. Vanguard, as explained by Smart Money came last because it caters to fund-investors instead of stock-investors.

TradeKing grabbed “Best Discount Broker” although it is only a new-entry discount broker. Following the lead are Firstrade, OptionsXpress, Muriel Siebert, Scottrade, ThinkOrSwim, and WallStreet*E.

In the “Best Full-Service Broker”, Merrill Lynch is tagged-along by SmithBarney, Edward Jones, A.G. Edwards, Wachovia, Morgan Stanley, and UBS. Merrill Lynch replaced last year’s first-place Edward Jones because of the latter’s below-average stock-picking. Other special determinants used by Smart Money for their “Best Full-Service Broker” aside from the brokerage firm’s stock-picking are customer satisfaction and trust and statements.

Overall, the Daily Record recognizes Smart Money’s survey of the best brokerage firms. These may serve as good guide for people engaged or deciding to engage in brokerage, and also as good guiding-principle for self-company assessment of the forerunning brokers themselves. The outcomes of the study at least are good only for this year’06 – Just for the record.

Regional Brokerage Firms

Some real estate investors want to receive the kind and quality of services provided by big brokerage firms at lower cost, while enjoying the attention that is given to them by smaller firms. This is because, apart from security, they also want to have a firm that can give them personalized services. To be able to get these services, most of these investors go to regional brokerage firms. They do so because it is perceived that quality regional brokerage firms can provide the expertise of larger firms, and they can also deliver the attention to their clients often given by smaller brokerage firms.

Regional brokerage firms

Given the increasing demand for this type of service, most regional brokerage firms have employed a different strategy that can help them better position themselves in the market. One of these strategies is a re-affirmation of a “sales culture” within their organizations, which can help these firms set and reach their sales targets.

Another strategy is being pro-active in looking for opportunities outside their localities and exploring other opportunities within the region, which increases their chance of getting more business as they look outside the “box.” These firms have also changed the way they compensate their brokers. Most of them have adapted compensation that not only encourages brokers to get more business, but also help the firms retain competent brokers and specialists.

Most of these firms also become members of established broker associations so that they can be perceived as having a very good track record. Being a member of these organizations also assures clients that the firm is supported by a larger organization. More importantly, these firms have put in place systems that will allow them to evolve in the future as the demands of the market change, so that they can remain competitive. By doing so, these regional brokerage firms have successfully answered the call of the times by undergoing paradigm shifts that can equip them to meet the demands of the future.