Selecting a Futures Broker

Commodity Futures Brokers - Making The Choice

One of the most important decisions when trading futures and options is choosing a commodity futures brokerage firm and an individual broker.

There are many types of commodity futures brokers and choosing the right one can be an important factor in your success in trading futures. In choosing a commodity futures broker, several factors should be considered:

  • Clearing arrangement
  • Ethical business record
  • Length of time in business
  • Commissions
  • Type of service

Clearing Arrangements

There are two major types of brokerage firms:

  • Futures Commission Merchants, Clearing and Non-Clearing
  • Introducing Brokers, Guaranteed and Independent

Futures Commission Merchant (FCM): A Futures Commission Merchant Is an organization that solicits or accepts orders to buy or sell futures or options contracts and accepts money or other assets from customers in connection with such orders. FCM's can solicit business directly, but most act as exchange liaisons for Introducing Brokers. An FCM can be either a clearing member of an exchange (a "clearing FCM") or a non-clearing member of an exchange (a "non-clearing FCM"). Clearing members are a select group of FCMs that maintain very large capital deposits with exchange clearing firms. Clearing deposits are used to guarantee transactions in the unlikely event of a default by both the trader and the member firm. A non-clearing FCM clears trades through another FCM that is a clearing FCM, another way of looking at this is that the non-clearing FCM is the direct "customer" of the clearing FCM.

Introducing Broker (IB): An Introducing Broker is a futures broker who delegates the work of the trade execution, floor operation, back office operations, etc. to a Futures Commission Merchant. While the FCM maintains the floor and back office operations, the IB maintains the relationship with its clients. An IB is not a branch office of a FCM or middleman but is in a business partnership with an FCM, each handling their own responsibilities.

  • Guaranteed Introducing Broker (GIB):
    An introducing broker that has an exclusive relationship with an FCM. All of the accounts of a guaranteed introducing broker must be carried by the guaranteeing FCM. In return, the FCM uses its capital to "guarantee" the operations of the IB. By using guaranteed IB your account is backed by the capitalization of the FCM, not your IB.

  • Independent Introducing Broker (IIB):
    An Independent Introducing Broker is self-guaranteed and must maintain its own minimum capital and can trade with one or more FCMs. While the term "self-guaranteed" may sound less financially secure than guaranteed, these IBs are generally very stable due to their willingness to maintain their own capital base. The National Futures Association (NFA) maintains strict financial requirements for non-guaranteed firms and carefully monitors compliance. However, Independent IBs may be a small "mom and pop" shop with no backing above their capitalization. It is important to make sure that the brokerage firm you are doing business with is adequately capitalized.

Ethical Business Record

The brokerage firm you do business with should be of the very highest moral integrity. The firm should always have your best interests in mind and resolve any customer's problems in a fair and equitable way.

Take the time to contact the National Futures Association and find out if there are any disciplinary actions against a broker you are considering. If there are, ask the broker to explain the circumstances before dismissing them from your list. Firms with a long business history may have a few disagreements or complaints with clients, which are addressed in arbitration, and hence a reparations record is kept. It must be cautioned however, that a firm's NFA record may not necessarily reveal the integrity or lack thereof of a firm or an individual. A firm may have a clean record because it is newly registered, but be run by principals and brokers that have entire careers being associated with unethical and disreputable firms that have been permanently barred, suspended or expelled from the industry. Or perhaps a firm might generate an enormous amount of customer complaints but settles them before the customer files a formal complaint with the NFA. No record is therefore generated and hence the firm posses a "clean" NFA record.

Take time in choosing a commodity futures broker. Talk to friends or other traders for referrals, contact industry professionals or industry organizations such as the National Introducing Brokers Association, to help in your search.

A Note About Disreputable Firms
In every industry there exists a small percentage of disreputable firms and individuals. The commodity futures and options industry is no different. In the commodity industry, disreputable firms almost invariably take form of the "option chophouse". These boiler room operations utilize the futures and options markets only as a vehicle to separate their victims from their money. They peddle buying options over futures contracts because commissions are charged up front, no margin calls or deficits are possible, and most importantly they can sell more options than futures. They engage in the practice known as churning, or "rolling the money" in the vernacular of the option chophouse. This practice generates enormous commissions - often as much as 90% of the account value in just a matter of a couple months. Commissions are only generated when new options are purchased, so if the options break even after commissions or become even slightly profitable they are offset to free up cash to "roll" again. If the options start to lose just a little value, they are also quickly sold to maintain the cash to "roll" again. Trading recommendations are not in good faith and serve no other purpose than to enrich the broker and convert the client's "investment" into commissions. Be wary of any firm that charges more than $90 round-turn or that recommends you spend all the in funds your account on the first trade.

Length Of Time In Business

Most new businesses go out of business in the first 5 years of operation. The attrition rate for futures brokerages seems to be higher - many lasting less than 3 years. You should consider futures brokerage firms that have been in business at least 5 years. By this time the brokerage firm has proven it's viability and should have enough experience to deal with the day-to-day operations associated with the business.

Commissions

Commodity trading tends to generate a large number of trades. Therefore, commission expenses can be an important factor affecting your profitability. However, we do not believe that commission rates should be the most important consideration when choosing a broker, especially for those new to trading. New traders may choose to use a discount broker, and due to inexperience when placing orders, lose more due to poorly placed orders and errors than the money "saved" with the lower commission rate. Brokers get paid for the service they provide. An experienced broker understands the markets and can interpret the market's changing dynamics to determine the best price and order type to use. It takes experience and intensive monitoring to "work" an order...to know where the market really is, if there is enough volume to get filled - even if the bid-offer price (that changes constantly) is fair, keeping the client updated, etc. The better fills alone could more than make up for the increased full service commission rate.

Commissions vary from firm to firm, and client to client. Commissions are usually negotiable, depending upon your account balance, trading experience, and trading frequency. Commission rates at deep discount brokers can be as low as a few dollars per round-turn if you have a high level of trading activity and a large account balance. Discount rates range from $25 to $40. Full service commissions typically start around $40 and can be as high as $85. A "round-turn" commission is a completed transaction: in and out of the market. Some brokers may charge you on a "half-turn", half in and half out. Most brokers charge the full commission when you enter an option order and nothing when you exit. In our opinion, the maximum any firm should charge is $85 round turn.

Type Of Service

The criteria for selecting either a discount or full service broker depends upon the support and the services you need to effectively trade the markets. Regardless of whether you use discount, full service, or something in-between, you want an efficient firm that will provide good execution performance.

Discount Brokerage:
A discount brokerage firm allows you to make all the decisions about how to trade your account. You only need to call, place an order and the firm will execute it. You will also, in many cases, conduct your own research on products. Support is limited, but if you don't need the extra attention and are confident in your trading abilities, this is the most economical way to trade.

Full Service Brokerage:
If you're following several markets; you may want the experience and assistance of a full service brokerage firm. Your trading strategies will be a joint effort between you and your broker. If you're new to futures trading, you might feel more comfortable with the extra attention that a full service brokerage extends. A full service firm offers you advice on investments currently in the news, provides you with data so that you'll be knowledgeable in several areas, and contacts you regularly with trading advice, etc. Transaction fees are generally higher because of the additional services they provide.

Selecting A Broker

Once you have decided upon a firm, you should then decide on an individual broker. When selecting a broker, remember that you are developing a long-term relationship. Individual brokers vary greatly in experience and style so make your choice carefully. You should be comfortable with your broker's personality, experience, knowledge, services, and commission structure. The two most important criteria in selecting a broker are experience and honesty. There is no substitute for these two qualities. Experienced brokers are familiar with all types of orders, strategies, and nuances of the market. They should be as knowledgeable about grains as they are about the energy markets or stock index futures. Experienced brokers have dealt with the full spectrum of economic environments and a wide variety of market factors and are more likely to direct you to the right action under most circumstances. Honesty - it goes without saying you that must trust your broker. You want the broker who cares about you, your account, and your orders.

Make sure your broker fully understands your objectives for getting into the market. Is it strictly to take advantage of price fluctuations? Do you want to hedge a risk exposure you may be carrying on your product? Communicate your goals up front so you will both know whether or not the broker's experience fits your needs. Beware the broker who promises to make money for you all the time. This is nearly impossible. A broker with integrity will not promise anything that's not deliverable.

After choosing a broker, you will be asked to provide personal and financial information. Be sure you carefully read and understand all material before signing anything. If you have a question, don't be afraid to ask. Don't be put off by the amount of material you may be required to sign. Never exaggerate your financial statistics such as net worth or the amount of risk capital you have. Be very cautious and avoid brokers who suggest being less than truthful on your account forms. It is for your protection that commodity laws require these statements.

Good Brokers

  • Are knowledgeable about the markets.
  • Keep their clients informed about the market and the conditions of their accounts.
  • Have good personal contacts in the marketplace that often can provide background information on market news that is not otherwise readily available.
  • Do not pressure clients to trade.

Questions To Ask When Interviewing A Futures Broker

Does the broker have a working knowledge of the fundamentals and technicals of the commodities you wish to trade?
 This is an important question if you are looking for a broker to provide price outlook and advice. You don't want to be limited in the trading opportunities you can pursue due to the broker's lack of knowledge. Consider whether or not the broker is willing, to better service your account, to bring his/her level of knowledge of selected contracts up to a standard with which you feel comfortable.

What is the minimum size account they are willing to accept?
 You should have received this information in the packet sent to you prior to your meeting. If it was not included, you need to know this up front, in case the broker or firm requires a higher initial amount to start than you are willing to put into a trading account. During this discussion you should also talk about the firm's margin requirements and call procedures. Firm can have different policies regarding margin.

What services does the broker offer and what are the commission fees?
Ask the broker about commission charges. As with most businesses commissions vary with the amount of service. Also, make sure you understand all additional fees for value-added services.

What is his/her track record like?
Find out if the broker has been in business for a long time. Is the broker willing to keep abreast of new trading techniques and strategies? Is the broker responsive to clients' trading ideas? If the broker handles many clients, is there time for personal attention? Are most of the broker's client's commercial hedgers, speculators or a mix of both? Most of these questions will be answered if you check his/her references.

How are issues handled?
Find out the brokerage firm's policies and procedures regarding trading issues. Who should you contact regarding questions about your account statement or disputed orders?

Conclusion

Choosing a brokerage firm and individual broker is a very important decision. Although no brokerage firm can guarantee that you will make money, choosing one that will handle your account with the highest degree of integrity and professionalism will enhance your trading experience.

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