Direct-Access Treats at Mainstream Brokers

Mark Ingebretsen

While markets this week were roiled like a Jacuzzi run amok, three mainstream online brokers announced new products aimed at helping active traders stay afloat.

Datek Online debuted a trading platform called Datek Direct that allows customers themselves to route orders directly to the market, either to a market maker or an ECN (electronic communications network).

Meanwhile, direct-access broker A.B. Watley said E*Trade(EGRP) soon will begin using its direct-access trading software, which has capabilities similar to Datek's.

FreeTrade.com, Ameritrade's(AMTD) zero-commission affiliate brokerage, began letting customers trade options (though not for free).

Direct Access for Everyone

The announcements by Datek and A.B. Watley/E*Trade provide the best proof yet that direct-access technology isn't just for daytraders anymore. It's about to go mainstream. And that's exactly what TSC readers told us they wanted to see in our broker survey this fall.

For a more complete explanation of what direct-access trading is all about, read our recent report that also includes the results of our broker survey. Here's the short explanation:

Direct-access trading differs from mainstream trading in how orders get executed. Direct-access software automatically searches the entire market for the best price when you send your order, or lets you choose how your orders get executed. Or, you can "preference" a particular market maker or ECN, then buy or sell shares from that source with a single mouse click. It's that last-mentioned service that Datek and E*Trade are now going to offer.

Direct access is a big change from the way orders by mainstream brokers typically get filled. Well-known brokers like Schwab(SCH), Fidelity and Mydiscountbroker.com routinely route their customers' orders to the market-making firms with whom they've partnered, and get paid for the gesture. Market makers buy shares at the bid and sell them at the higher ask price, profiting from the spread, or the difference, between the two. At least that's what happens when you send out a market order, which is executed at whatever the prevailing price happens to be.

Let's say you send a limit order , and the order's price is inside the prevailing bid-ask spread. When that order gets routed to a market maker, Nasdaq rules require him either to fill the order himself or to route it to an ECN for execution. Routing the order to an ECN can cause a delay, which in a fast market may prevent the order from getting filled.

Direct-access brokers give customers a faster, more reliable way to receive fills that are inside the spread. If the order happens to be at the best price at that moment, which would be the case if it fell inside the spread, it instantly appears on the quote displays of everyone watching that particular stock. Direct access gives you a far better way to advertise the price you're willing to accept.

Getting inside the spread saves you money. If you shaved 1/16th of a point off of the price of a stock each time you bought and sold it, for example, you'd save $25 on a 200 share round-trip trade. If you made 10 trades like that each month, you'd save $250, or $3,000 a year! See why active traders demand direct access?

Special Benefits of Preferencing

Momentum traders who profit when stocks make fast moves have even more reasons to love direct access, especially during volatile, high-volume days, as happened this past week. That's when preferencing really comes in handy. You can choose to forgo the best execution to ensure execution at a price of your choice.

Let's say you feel XYZ stock is about to move up by a point or more. Other traders might feel the same way, so you need to gobble up shares fast. You glance at the Level II order book, which shows the list of prices people are willing to buy and sell the stock for, starting with the best bid and offer. Then, by hitting -- that is, preferencing -- specific sellers, you route your order directly to each of the sellers, whether they be a market maker or someone advertising shares for sale on an ECN. The prices of the shares you buy will be fractionally higher than the best ask price. But by hitting these higher ask prices ahead of other traders, you pretty much guarantee that the trades will get executed. The shares will be yours to sell if the stock rises, as you hope it will.

Until now, Datek customers haven't been able to preference orders. Datek does own Island ECN, so customer orders were routed there first. If a best price couldn't be found on Island, the order was automatically rerouted to the market, where a market maker or an ECN might act upon it. With Datek Direct, orders still will go to Island first, even if you preference another ECN or a market maker. If a match isn't found, it then goes to the ECN or market maker you preferenced, a spokesperson says. The millisecond side trip through Island shouldn't slow down the execution, said the spokesperson. "We just think there's great liquidity there." Not to mention the fact that Island is a Datek subsidiary, which Datek is spinning off.

Datek, which has rolled the Direct product out to a beta group, plans a full rollout, along with a browser-based Level II order book by the start of the new year.

An A.B. Watley spokesperson said its system would be up and running on E*Trade sometime around the first quarter of 2001. Which customers will have access? An E*Trade spokeswoman did not return a call for comment.

The developments are not altruistic. Active traders presumably make for even better customers during nasty bear markets. While the rest of us hoard cash, the best active traders gleefully exploit the volatility, going long one day and short the next. Several traders tell me they've actually traded more since the April crash, wracking up more commissions for their brokers in the process.

Where to, Active Traders?

Will Datek and E*Trade's new services, combined with their lower commissions, lure traders away from original daytrading brokerages, such as CyBerCorp.com? Hard to say. Many daytraders like to stick with an execution platform once they've mastered it. Also, the Datek trading platform will be browser-based. (No firm word yet from E*Trade.) Some traders prefer the client-server model in which the execution software resides on the desktop.

Options, but No Frills

There's another method some traders use to ride out choppy markets: using options either as a hedge or to gain leverage. (The Chicago Board Options Exchange operates an excellent educational site that explains options strategies.) FreeTrade.com began letting customers trade options on the first of December. FreeTrade.com stirred up the industry last May when it announced its commission-free business model.

FreeTrade.com's commissions for options orders aren't free. They're identical to what Ameritrade charges for options trading: $8 plus $1.75 per contract for a market order, plus $5 for a limit order. Often a limit order's more than worth the price, because the spreads on options are typically much wider than with stocks.

Option limit orders can have a tougher time getting executed. There's simply not enough liquidity. For that reason, some options traders like having a professional manually handle their orders to ensure a rapid execution at a good price.

FreeTrade.com is for options traders who don't need hand-holding. The brokerage responds to emailed questions or complaints. No phone calls allowed. So unless you've got a lot of experience with options, this probably isn't the best place to park your portfolio. (Readers of this column continually remind me that InteractiveBrokers.com charges only $1.95 per contract for options trades. And it answers its phones.)

No-frills options trading? I'm not sure that'll fly. Making direct-access trading available to the masses, on the other hand, sounds like a much better idea. Millions of Americans now have several years' experience trading online. And no doubt many are ready to use trading tools designed for grown-ups. Anyone out there using Datek Direct? Anyone have plans to use E*Trade's direct access software when it debuts? Please let us know what you think!

---