The Online Trading Boom

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A few years ago, only a handful of online brokers were in business. Today, nearly 200 firms are competing for your online trading business. The growth in the number of online brokers is due to the growing popularity of online trading. For example, trades at the top ten online firms currently account for 30% of the trading volume on the New York Stock Exchange and the Nasdaq. By some estimates, the number of online trading accounts in the United States will reach 20 million this year and double over the next five years.

Given the popularity and anticipated growth in online trading, why have online brokerage stocks spent so much time in the doghouse? Consider E-Trade for instance. The stock was trading as high as $63.00 a share in April of 1999, but by the third quarter of 2000 the stock fetched less than $20.00. The performance of Ameritrade has also been a bit of a disappointment. It was above $60.00 in the spring of 1999, but by October 2000, the stock had dropped to a little over $17.00 a share. What gives? In an era of do it yourself investing and online trading, why are the web broker stocks suffering steep prolonged declines?

One reason is simple: competition. Full service firms have become increasingly interested in capturing business from their online rivals. Merrill Lynch, Salomon Smith Barney, Morgan Stanley, Dean Witter, and others are launching online products designed to give investors the same fast real-time trading. This phenomenon is creating a huge amount of competition among online brokers and is driving commission levels to rock bottom. Some brokers are now offering free trades. Financial Café.com and Ameritrade offer free market trades. A new online broker, FreeTradEZ.com is offering free market and limit orders. These brokers hope to earn enough from ad sales to offset the absence of commission revenues.

While the competition from all of these competing firms is making things more difficult for online brokers, there is also evidence that the growth in online trading is leveling off. A study by JD Power and Associates found that online trading might have reached a peak in 1999. Specifically, of 2,000 households with over $100,000 in investments, 35% had traded online over the past year, up only 1% from the year before. In 1998, a mere 17% had traded online. Therefore, there is evidence that the phenomenal growth in online trading may have reached a temporary plateau.

With the increasingly competitive environment and the slower overall growth in online trading activity, brokers compete for market share by using various strategies. For many brokers, the key to success involves adopting a combination of both online and traditional brokerage services. In fact, two of the largest online brokerages (Charles Schwab and TD Waterhouse) attribute their success to having branch offices. Apparently, many investors feel more comfortable opening accounts and bringing in assets when there is face-to-face contact.

Online brokers are not overlooking the importance of branch offices. For instance, Schwab opened 23 new offices in the first half of this year. DLJ Direct opened an office in Florida and Webstreet has opened branches in Boston, Beverly Hills, and San Francisco. The recent volatility in the stock market and subsequent trading losses has left many investors questioning the prudence behind do-it-yourself investing. Consequently, many have opted to keep online trading accounts, but also find a place to turn for financial advice. Having both an advisor and the ability to trade online is an appealing arrangement for some. A number of brokers are realizing this and adopting strategies that use both online trading and traditional brokerage services to lure new accounts.

Other brokers are competing for market share through technology and the rise in online trading abroad. Goldman Sachs, for instance, recently announced plans to launch an online trading platform that will enable European investors to trade European and US stocks online. E-Trade is also building an international presence and is active in ten countries. JP Morgan estimates that 7.1 million investors will be trading in Europe by the end of 2001. Ultimately, these companies hope to become global financial services corporations.

A final strategy is simply to offer no frills trading, low costs, and quality execution. Active traders are an important part of the investment population. Most are experienced investors with little need of advice, branch offices, or other extras. Instead, active traders prefer a broker with low costs and exceptional execution capabilities. The strategy for many web brokers is to maintain a focus on low transaction costs and superior trade execution to attract more accounts.

Investors and traders will eventually figure out the type of broker best suited to meet their needs. For instance, an active trader is unlikely to find much value in being able to visit a branch office and chat with a stockbroker. A relatively knowledgeable trader will probably have a thorough understanding of financial markets and investment risk and not require meeting a stock broker face-to-face. In reality, the active trader needs a no frills, low cost broker with a focus on getting the best prices on customer orders. Therefore, as an investor, when evaluating various brokers, the most important factor to consider is whether or not the broker focuses on those factors that are going to add value for you and your particular investing style.