Stock talk for the main street investor.

Interactive Brokers

I’m a few days late. I apologize to my three regular readers.

Last time I wrote I talked about how increased volume on exchanges is helping NYX and how this can act as your personal tax on Wall Street. I also mentioned their biggest risk factor being the rebates demanded by market makers. Let me explain how this works and how Interactive Brokers (IBKR) fits in.

When you go to buy or sell a stock there has to be a counter-party to take the other size of the trade. These are market makers and they sit on the bid/ask of almost every stock. For instance if I’m a market maker in Starbucks (SBUX) as it’s currently trading I will buy at $24.77 if you want to sell or I will sell at $24.78 if you want to buy. You as the investor lose that $0.01 spread as a payment of liquidity to the market. This may not seem like a lot but if you trade 100 shares at a time, multiple times per minute, the profits add up quickly.

On top of this spread premium, the exchange actually pays market makers to trade. So the exchange charges you (the price “taker”) a fee, which is part of the cost for your broker, and part of that fee goes to the market maker as a price of providing liquidity. This liquidity fee is currently in the range of $0.002-$0.003 per share. This is how banks make a lot of money trading.

This is also why I’m looking at IBKR. They have two basic functions in their business, brokerage and market making. Gross margins in the market making business are over 60% and brokerage is nearing 50%. IBKR has done an outstanding job of building the electronic infrastructure to automate most of their business activities which allows them to focus on gaining more customers, growing 30% in the last two years.

I like the trends, the business model and I’ve heard great things about their majority owners. The challenge is valuing the company. Earnings can be very choppy in trading activities especially in challenging times like the last two years. Their current P/E of 18 is reasonable given their upside potential. I also like that they’re market value is only about 1.2X book value. Look for more stable earnings as the market settles down.

Disclosure: The Mayor has no position in IBKR or NYX.

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