I have now written a few posts on how to start an investment portfolio, so I thought it was time to explain the different types of online brokerage accounts. This can seem intimidating but these days there are so many online choices for brokers that it has become quite simple and straight forward to trade online.
How do brokers work?
If you have never used a broker before I’ll outline here the different types of brokers and their histories. Brokers have been around as long as the Stock Market and started with full service brokers long before the invention of the internet. You would phone in your trade to a full service broker (or ask for trading advice from your broker) and he/she would place your order for you through their brokerage computer system. Of course, you would pay for the privilege of their advice and the placing of your order, usually with a minimum commission payment or a percentage of the order you are placing (whichever was the higher figure). These commissions could be quite substantial $80-150 per share purchased until this was replaced by the advent of the discount brokerage houses in the 1980’s. Once discount brokerage firms appeared during this period panic set in at the full service brokers because they thought their businesses were being threatened. Instead of being ahead of the pack and diversifying to include discount brooking in their business models, many full service brokers ignored the inevitable and suffered the consequences. These days you can still find good full service brokers but they usually have well trained staff and have become proxy Financial Planning/Advice/broking – all in one stop shops. For those investors that have improved their financial education it is now very easy to lodge your own trades online for very little cost. It has been a revolution in just a couple of decades!
Types of Brokerage Accounts
Today there are many brokerage accounts available and it can become confusing to someone who is new to the share market. Here I’ll try to explain the different accounts.
Firstly it’s important to know the difference between the Real Market and the CFD (Contracts for Difference) market. I won’t go into great detail here about Contracts for Difference because there is heaps of information available on the web – just Google CFD’s to find out. The real difference though is the cost to you. If you trade in the real market on an Index or Share you will need to pay the price per share online e.g.. BHP shares are currently $39.00, so if you want $10,000 worth you would buy 256 shares (not allowing for brokerage etc). Brokerage rates on the Real Market can be very low (as low as 0.58c to $1 per 100 US shares), so 256 BHP may cost you as little as $3.
The CFD market works differently. You are borrowing money (they call it Margin) to leverage a position into a share purchase and they will also charge you a commission on the purchase. For the BHP example above I will show you what online brokerage costs would be.
Minimum commission AUD $5.00 or 0.08%, plus 5% Margin factor, plus daily financing costs (because you’re borrowing on margin from the broker). Stay with me now!
256 BHP shares (as above) = $5.00 commission + $500 margin (10,000 x 5%), plus daily financing (RBA cash rate 2.5% + 2.5% holding costs/365) = $5 commission + 5%/365= $1.36 per day, $9.58 per week or $496.40 per year. So in the first year it will cost $5+496.40 = $501.40 to hold $10,000 worth of BHP shares.
So in conclusion, buying on the Real Market will have less costs but you will have no cash left. With CFD”S, the costs are greater, $501.40 per year but you only use $500 of your margin. You would still have $9,500 of margin left on a $10,000 account to buy more shares.
There is a very stark word of warning though with CFD’s! This example above is a best case scenario. If the BHP trade goes against you and you begin to loose money the margin amount also increases so you must leave a safety buffer in your account to allow for this.
Soon, I’ll write a post on opening a brokerage account, use a broker as an example and give you a few to choose from.
See you then.