Online trading

This article concerns securities trading on the Internet or Online Trading. This method of trading evolved as technological advances changed the way in which investment products are bought and sold. With the advance of technology, securities trading in general became more automated. Moreover, as the Internet expanded, it became a marketplace for a variety of consumer goods which led to the creation of an electronic securities trading market. In the beginning, discount brokerage firms developed software that enabled customers to buy and sell securities online. The online trading industry continues to evolve as brokerage firms and other financial institutions are offering more traditional investment services while providing other financial services as well, and social media platforms and cloud-based data storage are now affecting how online trading is done. This article is an overview of the evolution of online trading and includes a discussion of new trends in the ever-growing field of securities trading.

Keywords Asset Valuation; Commission; Day trader; Discount broker; File Transfer Protocol; Internet; Internet Service Provider; Limit Order; Margin; Market Order; NASD; NASDAQ; Net Worth; New York Stock Exchange (NYSE); Online Trading; Patriot Act; Risk Management; Sarbanes-Oxley Act; Securities and Exchange Commission (SEC); Stocks; Stop Loss; Time Value; World Wide Web

Finance > Online Trading

Overview

The Internet has become a convenient avenue for people to conduct a variety of consumer and financial transactions. The ability of customers and commercial enterprises to exchange information electronically allows for credit card and utility payments, the purchase of and payment for consumer products, bank account maintenance, as well as for conducting financial transactions — including the buying and selling of stocks, bonds, mutual funds, and other investments. These financial transactions are commonly referred to as online trading. In order to understand online trading, a brief history of the evolution of the Internet and technological advances in securities trading are worth considering.

The Internet is the worldwide system of computers that exchange information electronically. The system was originally developed by the United States Defense Department in the 1960s in order to create an information exchange system that would enable key government agencies and the military to route data around failed electrical circuits in the event of a nuclear attack. By the 1970s, colleges and universities started accessing this information-exchange system in order to share research data. While the Internet remains largely unregulated, there are various standards and conventions, such as the File Transfer Protocol (FTP) and the protocol commonly known as the World Wide Web, that govern the storage, retrieval, and exchange of information.

Websites became more popular throughout the 1990s as numerous commercial enterprises began to exchange information and to communicate electronically through email with the assistance of such pioneering Internet Service Providers (ISPs) as America Online, CompuServe and Yahoo. Today, there are a number of ways to access the Internet and there are a broad array of services available that provide access to free information, data, software, games, consumer products, and banking and investment services (Russ, 1996).

As the Internet evolved and the information age began to advance, changes were also occurring in the way in which financial transactions were being conducted. This can be seen, in part, by the creation of NASDAQ — the electronic stock exchange established in 1971 by the National Association of Securities Dealers (the NASD). NASDAQ stands for National Association of Securities Dealers Automated Quotations System, and it is the market where most growth company stocks such as technology stocks are traded. Shortly thereafter, in 1975, the U.S. Congress deregulated the stock brokerage industry and one major change was the elimination of the New York Stock Exchange's (NYSE) ability to set commission rates charged by its members. This led to the establishment of discount brokers, who took orders to buy and sell securities, but these companies did not offer investment advice or perform research. Since the administrative expenses were far less than those incurred by traditional brokers, this new breed of brokers was free to offer buy and sell services at a discount (Stefanadis, 2001).

In addition to limiting their services to placing buy and sell orders for less money, discount brokers attracted a more savvy group of investors. These investors were quite often people who were employed in the financial services sector or who had experience with investments and were looking to trade for their own accounts. They also had the time and ability to perform their own research as well as to conduct due diligence. In order to do so, an investor needs to have an understanding of the basic concepts of finance such as the time value of money, asset valuation, and risk management. Moreover, these investors need to be able to analyze financial statements of publicly traded companies in order to determine their net worth, profits, losses, and revenues, all of which are critical to asset valuation.

As the demand for services of discount brokers began to grow, these companies began to develop software programs and construct hardware platforms that enabled investors to actually conduct financial transactions in real time over the Internet. These investors came to be known as day traders. Day traders are investors who buy and sell stocks during the day with the goal being to make profits as the value of those stocks changes throughout the day (Landis, 2004).

In order to do so, day traders use money that is borrowed, and this is known as buying on margin. Buying on margin is not a new practice as financial service professionals, investment companies, and sophisticated investors have bought and sold stock on margin for quite some time. Moreover, buying on margin is a practice that is regulated by the New York Stock Exchange (the NYSE) in conjunction with rules established by the NASD. However, it is a risky practice and an inexperienced investor can suffer large financial losses. While there were pre-existing regulations in place governing margin transactions, in April 2001 the NYSE promulgated stricter guidelines for margin trading being conducted by day traders (SEC, 2005).

The advent of online trading by the discount brokerage firms led to the establishment of new business enterprises that specialized in conducting stock transactions on the Internet. Some of the early companies in this field were Charles Schwab Corp., Fidelity Investments, TD Waterhouse, E*Trade and Ameritrade (TD Waterhouse and Ameritrade eventually merged to form TD Ameritrade). Not only did these entities lead the way in developing a new form of securities trading and establishing a new type of business enterprise, they have also had an impact on the greater financial services market by branching into more traditional consumer finance services like check writing, electronic bill paying, and issuing credit cards and debit cards (Snel, 1999).

The NYSE and the NASD, as well as the U.S. Securities Exchange Commission (SEC) along with other state regulatory agencies, all regulate the securities industry as had been the case prior to the development of the Internet and the advent of Online Trading. Moreover, the early twenty-first century has been a period of increasing regulatory scrutiny of the financial services sector. Important developments in this regard have been the increased financial reporting requirements of the Sarbanes-Oxley Act of 2002 (SOX), the compliance requirements of the Patriot Act, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and the Jumpstart Our Business Startups Act of 2012.

The Sarbanes-Oxley Act is a federal law that requires publicly traded companies to file yearly financial statements more promptly than in the past (prior to SOX, firms were required to provide annual financial statements 90 days after the end of fiscal year; the requirement is now 45 days). Publicly traded companies are also required to provide quarterly financial statements, and senior management is required to attest to the accuracy of these financial statements. The Patriot Act became Federal law in October 2001, shortly after the events of September 11th. The Act incorporates previous laws aimed at curtailing money laundering and bank fraud and its intent is to prevent the financing of terrorist activities by requiring financial institutions to verify customers' identities. This has had far reaching implications for investors and companies alike, especially as it relates to online trading. For investors who trade online or otherwise are involved in buying and selling securities, having quicker access to financial statements, and the increased scrutiny of those financial statements enables investors to have a better picture of the value of assets underlying potential investments. At the same time, the requirements of SOX and the Patriot Act have required companies to enhance their technology across the board in order to prepare and file financial statements more expediently, as well as to confirm the identities of customers (Hintze, 2005).

Applications

The concept of buying stocks online might sound easy to some, but online trading, much like placing buy/sell orders with discount brokers, requires an investor to have an understanding of financial investing. Although online brokers have expanded their services over the years by offering research and analytical tools to customers, full service brokers still provide investment advice and long term financial planning. Accordingly, investing online requires an investor to consider a number of factors.

First, investors need to know what their investment objectives are. There are different types of investment strategies, such as investing for value, growth, or income. Investing for value requires investing in larger companies that have a proven track record of profitability, and investing in these entities usually means holding the stock for a long period of time. Investing in a growth company entails investing in new businesses that are bringing new goods or services to the market that have growth potential. To invest for income means to invest in companies that pay dividends on its shares of stock. Moreover, investors need to determine what their long term and short-term investment goals are and to what extent they can assume the risk of losing their investment (Belkiaris, 2003).

Once these decisions have been made, an investor can choose an online broker. There are now a number of brokers who provide online trading services and many of the traditional stock brokerage outfits, mutual fund companies and banks offer online trading tools as well. Further, the range of services offered by these entities, and the administrative personnel available for providing research and analysis varies. A lot also depends on how much and how frequently an investor intends to trade online, and the fees they are willing to pay for securities transactions. This is important because brokerage rates are typically based on the size and frequency of trades. Investors who trade more frequently get a discount. Price is not the only consideration, however, as investors also need to evaluate a website's functionality, whether research and technical assistance is provided, and whether stop-loss orders are provided. A stop-loss order is a customer order to a broker that sets the sell price of a stock below the current market price. This will protect profits or prevent losses if the stock drops.

After these determinations are made and an investor has registered for an online trading account with an online broker, he or she will be required to deposit and maintain a minimum balance in the account. Placing an order over the Internet requires an investor to know the stock symbol of the company as well as the exchange on which the company's shares are traded. An investor then needs to decide how many shares to buy and whether the purchase will be an at market order or an at limit order. An at-market order is an order to purchase the stock at the current market price, so the timing of placing the order is important since the value of stock fluctuates in real time over the course of a trading day. An at-limit order, on the other hand, is an order that sets the highest amount an investor is willing to pay for the stock.

After the order is placed and the trade has been settled, an investor will be provided with a transaction confirmation from the online broker. This confirmation is usually an email transmission, so it is a good idea for an online trader to print out the email and retain a copy in the event a problem arises with the transaction, as well as for tax purposes. Finally, shares that are traded online are registered electronically so online investors do not receive an actual paper stock certificate (Belkiaris, 2003).

There are risks that experienced investors must contend with as well. The first, of course, is the possibility of losing money. Depending on market conditions, stock prices can and do fluctuate during a trading day and by not placing an order correctly or at a price that is above the market rate, an online trader can lose his investment. There are also financial privacy and security issues to consider. This is an important consideration as the evolution of online trading has been followed by a rise in Internet securities fraud, and federal and state law enforcement authorities have conducted numerous cyber crime investigations. These investigations have uncovered illegal activities of computer hackers who raid online brokerage accounts, place unauthorized sales orders that online brokers process. The proceeds from the sale are subsequently wired to falsified accounts. In some cases, investors who were not actively monitoring their online trading accounts have lost all of their investments.

In most instances, hackers do not get access to investor accounts by breaking into the online brokers' systems. Instead, hackers are able to access accounts through home personal computers that do not have sufficient computer virus protection. In these cases, once a virus made its way onto an investor's personal computer, usually through an email transmission, the virus was able to access any financial information on the computer and automatically begin emptying out online accounts. In addition to not having sufficient virus protection, many investors have had account passwords that were relatively easy to crack or had not been changed for a long period of time. While the total losses from Internet securities fraud have been small relative to the total amount of assets now being traded online, investors, brokers and investigators are concerned about the effect cyber crime will have on the online trading industry (Borrus, 2005).

Viewpoints

Despite the fact that online trading is not the best means of buying and selling shares of stock for some investors, and while there has been a rise in Internet securities fraud, online trading has been beneficial to many securities brokers and investors. Once investors established Internet connections with brokerage firms, executing trades has become much less expensive. Further, brokers have been encouraged to enhance their trading platforms and computer software and this has enabled these companies to automate the order placement process. In so doing, brokers are able to limit the amount of administrative personnel necessary to process these transactions and this has decreased the cost of doing business.

The Internet has become a powerful device for providing financial information and investors now have access to more information about asset valuations. Also, investors have a means of exchanging information with each other by virtue of the countless Internet chat rooms and discussion boards where investors post tips and detailed analyses of a broad array of investments. This information has enabled investors to become increasingly sophisticated; many can effectively execute transactions without the assistance of a professional broker (Stefanadis, 2001).

Trading financial instruments on the Internet is continuing to shape the financial services industry. In order to compete more effectively with the large brokerage companies, many online brokers have begun branching out into other sectors of the financial and banking marketplace. For example, E*Trade, the Online broker that was originally located in Palo Alto, California has relocated its company headquarters to New York, and has established a mortgage bank as well. The company has moved beyond solely providing online trading services to provide its customers with mortgage loans, retirement planning, and other services.

This strategy is one that many other financial services firms are also employing. Essentially the goal is to provide customers with one-stop shopping for banking and investment products. There are, however, different schools of thought as to whether or not this trend will be beneficial to investors or to the financial services industry. Some companies contend that consumers will benefit from the aggregation of their financial accounts since it can enable them to access all of their financial information quickly and provide them with a means of transferring assets more expediently. However, there is no guarantee that investors will be comfortable with having all of their assets with one entity and all of their financial information stored in one location. Moreover, in light of the rise of cyber crime where hackers gain access to online accounts through home computers, investors do need to consider the risk involved with having their financial security breached.

The Internet age is continuing to evolve as rapid technological changes are also taking place in the telecommunications industry. The widespread use of smart phones and tablets gives people ready access to the Internet without even having to log on to a computer, and investors can track their investments and move money over these devices. With all changes in technology happening all the time, it is not clear how the new communications technology will change the way online trading will be conducted. At this point investors have benefited from the lower costs of conducting trades, having access to enhanced financial products, and mostly, from having more information at their disposal. (Stefanadis, 2001). The online trading industry continues to evolve to account for the rapid changes in technology. Market analyst Alexander Camargo said “Mobility and social media have come of age and are legitimate channels among online brokers. HTML5 and more advanced cloud-based trading platforms are just beginning to have an impact” (2013).

Terms & Concepts

Asset Valuation: The determination of the net market value of a company's assets on a per share basis.

Commission: Fee paid to a broker for executing a trade based on the number of shares traded and/or the total dollar amount of the transaction.

Day Trader: Investors who buy and sell stocks during the day with the goal being to make products as a stock's value changes throughout the day.

Discount Broker: A broker that takes orders to buy and sell stocks but does not offer investment advice or research.

File Transfer Protocol: An early protocol governing the exchange of information over the Internet.

Internet: The world wide system of computers that exchange information electronically.

Internet Service Provider: A company that provides a customer access to the Internet, also known as an ISP.

Limit Order: An order that sets the highest amount an investor is willing to pay for the stock.

Market Order: An order to purchase the stock at the current market price.

NASD: The National Association of Securities Dealers, a non profit organization established to standardize securities exchange practices and to enforce fair and equitable rules of securities trading.

New York Stock Exchange: The largest stock exchange in the world by dollar volume. Trades are conducted by buyers and sellers on the floor in auction format.

NASDAQ: The National Association of Securities Dealers Automated Quotations System, the first and largest electronic stock market.

Net Worth: The total stockholders' equity or net assets; the amount by which a company's assets exceed its liabilities.

Online Trading: The buying and selling of stocks and bonds over the Internet.

Patriot Act: Federal law aimed at preventing the financing of terrorist activities by requiring financial organizations to verify the identity of their customers.

Risk Management: The ability to value assets over time in order to minimize risk of the loss of principal.

Sarbanes-Oxley Act: Federal law requiring stricter financial reporting requirements by publicly traded corporations.

Securities Exchange Commission (SEC): The Federal agency that regulates securities transactions.

Stop Loss: A customer order to a broker that sets the sell price of a stock below the current market price. This will protect profits or prevent losses if the stock drops.

Time Value: Price put on the time an investor has to wait until an investment matures.

Bibliography

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Stefanadis, C. (2001, Spring/Summer). Trading places. Stern Business Spring Summer 2001. Retrieved January 25, 2007, from Stern School of Business/New York University http://www.stern.nyu.edu/Sternbusiness/spring%5f2001/brokers.html

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Suggested Reading

S., H. H. (2013). Online traders show loyalty. Money (14446219), , 75. Retrieved November 22, 2013 from EBSCO online database, Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=89450159&site=ehost-live

Salcedo, Y. (2004). Getting educated the online way. Futures: News, Analysis & Strategies for Futures, Options & Derivatives Traders, 33 61. Retrieved January 24, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=15241655&site=ehost-live

Shakshuki, E. & Abu-Draz, S. (2005). Multi-agent system architecture to trading Systems. Journal of Interconnection Networks, 6 283-302. Retrieved January 24, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=18140737&site=ehost-live

Weisul, K. (1998). Online traders: Changing the face of IPOs. Inter@ctive Week, 5 62-64. Retrieved January 25, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=1347307&site=ehost-live