The definition of an online broker is an intermediary between a buyer and seller of a financial instrument. They facilitate the purchase/sale for a fee or commission. With the advancement of technology, traders and investors alike can transact online, courtesy of online brokers. Read on to learn more about online brokers, including which one is right for you.
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Overview of an Online Broker
By definition, an online broker is one which facilitates buying and selling of a security over an electronic network. The transaction is usually effected through the broker’s proprietary trading platforms. This is opposed to the traditional method of placing orders via phone call.
Online brokers began to gain in popularity in the mid-to-late 1990s, facilitated by the development of high-performance computers and faster Internet connections.
Advantages of Using an Online Broker
Online brokers take the personal bias out of the equation, while traditional brokerages are often said to promote a standard package of investments, with some of them even blamed with promoting their partnered mutual funds.
Online trading is convenient, as you can place orders, check quotes and make changes from anywhere. It also facilitates faster execution of traders, helping to take advantage of the volatility in a better manner. Above all else, online trading is more cost-effective compared to trading through a traditional broker.
How Does an Online Broker Work?
Once you key in your order with your online broker and the order is placed in the database, it checks the different markets, including the NYSE, NASDAQ and ECNs, or electronic communication networks, which connect buyers and sellers.
The market that successfully matches the buyer and seller sends a confirmation to the brokers of both parties. The order, and the price at which it is executed, is made available to regulators as well as market participants. Once an order is executed, the exchange sends a contract to the brokers of both the buyer and the seller.
The brokers then do a T+3 settlement, meaning they have 3 days to exchange the cash and the shares. The money due to a seller will automatically be credited to his or her account.
How to Open an Online Broker Account
In order to participate in online trading, you need to open an account with an online broker. The right choice is key here. Once you zero in on a broker, you need to fill an account opening application form and provide documents for identity proof. The various documents/details you may be required to submit at the time of opening an account are:
- Personal information such as name, address and employment details
- Social security number
- Signature card
- W-9 form
- Two documents for proof of identity, including one photo ID
You also need to decide the method for funding your online account, which can be through electronic fund transfer, wire transfer, checks, stock certificates, etc.
Check our picks for the best online brokers for beginners.
Online Broker Fees
Online brokers charge a fee for the services they render, including for their website and infrastructure, relaying orders to the market, settling orders, and more. The brokers may also be charged a fee by the exchanges to use their infrastructure and connect to them, while they may also have to pay for interfacing with the banks for monetary transactions.
- Trading fees: This fee is charged on every trade you make.
- Fee for broker-assisted trade: In case you need assistance from the broker in the form of advice etc., fee levied will be substantially higher than the regular trading fee for self-directed trades.
- Account maintenance or inactivity fees: This is an annual fee charged for maintenance of your account and can range from $20 to $50. It is usually charged when your account balance falls below a minimum.
- Margin: Sometimes the broker lends money to the clients for trading. You will be charged interest on the amount loaned by the broker.
- Withdrawal fees: Some brokers levy withdrawal fees when you withdraw cash from your account.
Types of Online Brokers
A full-service broker offers a range of services, including trading, investment advice, research, retirement planning, tax tips, etc. Given the wide range of services they offer, the fee involved is relatively high when compared to a discount broker.
However, they serve as one-stop shop for all investment-related services. This category of broker may be apt for a beginner who is just starting out and needs some hand holding and resources to help him make informed investment decisions. Some of the sought-after full-service brokers include Charles Schwab, Fidelity Investments and Merrill Edge.
As the name suggests, these brokers service their clients at a discounted fee when compared to a full-service broker. However, their service is limited to just assisting in trading and does not include investment advice, research or retirement, estate or tax planning.
Robo-advisors are online platforms that offer algorithm-driven trading, with very little human element involved. These brokers operate by soliciting some basic information from their clients, including their present financial situation, investment goals, etc., and then use the information for advisory services or automatically invest client assets.
Cost-competitiveness, 24/7 availability, relatively small account balance requirement and efficiency are some of the advantages of using a robo-advisor. However, one may not be able to get personalized service from a robo-advisor.
Risks Associated with Online Brokers
The speed associated with trading online can work as a double-edged sword, as it can lead overenthusiastic traders to make costly mistakes. This risk can be mitigated to some extent by setting up safeguards, such as placing limit orders. The lack of handholding could spell trouble for some traders, especially when building a portfolio or rebalancing.
There are also concerns regarding security, as online transactions expose you to account hack risks. Technical glitches could also result in overpaying or clocking in excess losses.
Customer Service from Online Brokers
With the pretext of cutting down on overheads, online brokers often offer limited customer service, relative to full-service brokers. Sometimes, customer service is compromised in favor of convenience and speed. It’s crucial for you to determine how important that is when you make your online broker selection.
What to Consider when Choosing an Online Broker
Minimum Account Balance
Most online brokers have a $1,000 or more minimum account balance requirement. If you’d like to start with less, you need to scout around for brokers which mandate very little or no account minimum. The more money you have at your disposal, the more diversification you can hope to achieve.
Investment objectives of an average investor may range from safety to income growth to retirement savings to tax minimization. You need to decide on an online broker that suits your investing goals.
If you don’t plan to trade frequently, you should choose a broker who does not charge inactivity fees.
If you are a beginner, you might trade infrequently but need good educational resources to walk you through the maze of investing. A full-service broker may come in handy in such an instance. However, seasoned traders who are active investors could do well with a discount broker.
Given the volatility and rapidity associated with stock moves, a platform that allows fast execution of trades is essential for making profits. It pays well to check out how fast a particular broker’s website launches, even during peak hours.
Commissions and Fees
A careful analysis of commissions and other fees associated with brokers is very essential for cutting down on your trading costs. Often, brokers charge a low commission and advertise themselves to be the cheapest option available but load up all the charges onto other fees.
Therefore, a careful analysis of the commissions as well as the other fees is a must.
Discount brokers, in the name of cutting overheads, may not offer the best customer service. Look out for those online brokers that offer customer service around the clock and not just during business hours. Analyze the various forms of support available, such as live chat, telephone support, email, etc.
Other Services Offered by Online Brokers
Some brokers offer other financial services such as checking accounts and credit cards.
Although promotions could make one sway toward a particular online broker, it’s important to take a look at the bigger picture. The benefits of a big promotional offer may be completely offset by higher commissions and fees.
Range of Asset Classes
An online broker offering a wide range of asset classes, including stocks, bonds, CDs, currencies, commodities, options, futures, ETFs and more is a better bet. All of these types of asset classes will come in handy in order to build a diversified portfolio (and mitigate risk).
An online broker is a great way to start investing in your future. Whether you’re casually investing to plan for retirement, or looking to get into advanced markets like forex, there is an online broker for you.