RealMoney Silver - Get Schooled in Online Trading

Get Schooled in Online Trading
By Steven Smith
Senior Columnist
6/26/2007 1:55 PM EDT

Editor's Note: This column also appeared in Steven Smith's blog on RealMoney.com.

Buyouts and mergers-and-acquisitions activity are sparking consolidation across a multitude of industries, and the two prime reasons cited for this boom are valuation and synergies. But one buzzword that seemed to have died when the bubble popped -- "monetization" -- is actually alive and being applied to trading platforms.

As exchanges and brokers add products to their platforms, they are also beefing up their marketing to promote trading activity and increase profits. They're putting a special emphasis on investment education, particularly with regard to options. To that end, they're adopting the mantra of retailing legend Sy Syms that an educated consumer is the best customer.

Here are some ways to play the vertical integration, consolidation and education that's now happening in the world of online trading.

Index All Its Own

On Monday, the International Securities Exchange (ISE) launched the Electronic Trading Index (DMA), which is being positioned as a benchmark for electronic brokers, market makers, educational firms and exchanges. It offers a broad way to invest in the growth of online trading, particularly in options and other derivatives.

The DMA is made up of 18 components that include TD Ameritrade (AMTD) , which has the largest weighting at 8.01%; OptionsXpress (OXPS) ; and Charles Schwab (SCHW) .

The index also includes six publicly traded exchanges, such as the Chicago Mercantile Exchange (CME) , which has a 7.85% weighting that would increase to 14% if its merger with the Chicago Board of Trade (BOT) is completed; the IntercontinentalExchange (ICE) ; and the International Securities Exchange itself.

There are also market makers such as Knight Trading (NITE) and trading platforms such as TradeStation (TRAD) .

The index is up 3.8% year to date and has gained more than 26% in the past 52 weeks.

Pursuit of Options

Options trading volume has increased more than 30% in each of the past five years, compared with an average of 10% annual growth in equity trading. Aside from higher growth, options trading also offers higher margins. An option trade typically has a profit margin some 7 percentage points higher than fees on pure equity transactions.

Given these numbers, it's no surprise that both exchanges and brokers want to increase their option and derivative business. For the exchanges, this means consolidation. For example, the NYSE Euronext (NYX) merger was done largely to give the NYSE exposure to derivative trading. Brokerage firms continue to add new features and trading tools, such as one-click transactions for complex trades and position-risk calculators in hopes of making options an integral part of their customers' investing activity.

But just because you build it doesn't mean they will use it. So brokerage firms are finding that it pays to teach their clients.

"Options are a complex subject, and even sophisticated investors find they are not as knowledgeable as they thought," says Randy Frederick, chief of derivatives at Schwab's CyberTrader unit.

Frederick figures that the number of free seminars he'll give to customers at branch offices will double to around 20 this year. He'll also speak at numerous trade shows to try to attract new customer accounts. He says the cost of the seminars easily pays off in the form of increased trading activity.

OptionsXpress has also increased its educational offerings to the point that it now runs its own annual trading exposition that includes outside speakers and third-party vendors. The event is open only to customers with an OptionsXpress account.

While Schwab, OptionXpress and other firms are using education to monetize their existing client base, none is using it as effectively as Investools (SWIM) to acquire new customers and grow its account base.

In the Swim

Last September, Investools, one of the largest investor-education companies in the U.S, bought ThinkorSwim, a small but highly regarded online brokerage firm that caters to options traders. The reasoning for the merger is that Investools would be able to steer its education clients, which number around 70,000 per year, to open accounts with ThinkorSwim, creating a longer-term and more profitable relationship with its customers.

This strategy of using Investools education as the marketing arm for feeding new accounts to the ThinkorSwim brokerage platform seems to be working. While the total number of funded accounts remains relatively small at 35,000, ThinkorSwim is the fastest-growing online firm out there. In May, it added 5,775 new accounts, a 400% increase over the year-ago period, and client assets more than doubled to $1.7 billion from the year-ago period. Compare that with OptionsXpress, which, as of May, had 231,000 accounts and $5.3 billion of assets but added just 3,150 new customers in May.

Other metrics also show that ThinkorSwim is attracting desirable customers; its average account has $46,000, or more than double the $22,800 held in the average OptionsXpress account. It's interesting to note that OptionsXpress had a partnership with Investools from 2004 to September 2006. In the past few months, OptionsXpress has cited the rising cost of customer acquisitions for lower profit margins.

ThinkorSwim customers also are the most active traders. Its daily average revenue trades (DARTS) as a percentage of accounts was 71% compared with the industry average of 17%. Its customer churn was just 4.5%, giving it the highest retention rate among discount brokers.

"We've taken the best education platform and married it to the best trading technology," says Lee Barba, the CEO of Investools. Barba estimates that nearly 60% of people who take Investools classes will go on to open an account with ThinkorSwim.

Transition Period

But investors remain skeptical, as Investools shares have declined 40% over the past three months from a 52-week high of $17 to $10. Among the concerns is that, as the company changes its focus from education to trading, profits will suffer. Sameet Sinha, analyst at Kaufman Brothers, recently lowered his price target on the stock, saying that the new, lower pricing structure for classes "will bring down overall margins, since education remains the larger portion of revenues."

Barba acknowledges that the period of realignment will take time, but he is confident the company can maintain its growth targets for the remainder of the year and believes the company's strategy should pay off over the long term.