Rising volumes should have been a boon to online brokers, but the damn market won't cooperate.

Remember the daytraders? For a while, it seemed as if everyone in the world was becoming a daytrader: College kids trading from their dorm rooms, a grandmother trading from her wired fishing boat off the coast of Miami, even my aunt in Michigan trading from her lakeside cottage. The wind was at their backs and daytraders were going to rule the world.

It didn't happen. In retrospect, it seems that the first wave of Internet adoption was by an affluent, techno-ready group ready to embrace stock trading. But subsequent waves of Internet users weren't likely to take the plunge into daytrading.

The smarter online brokerages figured this out, so companies like Ameritrade and Charles Schwab embraced the buy-and-hold set by offering other services, such as online banking. Ameritrade partnered with NetBank. E-Trade went a step further with its $1.1 billion acquisition of Telebanc.

But these moves reflect a Gordian knot for online brokers: In order to grow as brokerages, they have had to attract customers who don't have much need for a brokerage.

That problem has been catching up with the industry for some time, hitting hard in the third quarter. Some of the declines can be attributed to the seasonality of the market: During July and August, trading volumes fell dramatically in all markets as many traders and investors went on vacation. Online brokers discovered the beach has greater appeal to customers than trading shares of JDS Uniphase.

Average daily trading on the New York Stock Exchange and the Nasdaq were down from the previous quarter less than 5 percent. But trading at online brokerages was down even more -- between 7 percent and 19 percent. As frantic daytraders represented a decreasing number of accounts, average trades per account fell.

The slowdown is driving investors from online-broker stocks. E-Trade is down 70 percent from its 52-week high, while Ameritrade is down 58 percent. Schwab has fared a little better, falling 30 percent.

As summer ended, it seemed like there would be some relief. "Things start to look a little bit better for these companies in the fall," says Gregory Smith, an analyst for Chase H&Q. "When trading volumes come up, their business picks up."

Unfortunately, this market has thrown another wrench into the works. It seems that online traders have a particular distaste for losing money. When the market is down, they don't trade. "Nothing is working," says Smith. "Everywhere people turn they keep getting slapped in the face. Every hot sector has turned cold, and these people really don't short stocks -- they just stop trading."

An online broker like E-Trade that moved early to diversify are in a position to be better insulated from a long-term market downturn. "I look at [E-Trade] and I think they're one of the success stories of the Internet," says Smith. "I think they've got a shot at being a major firm five years from now. They're diversifying revenues into banking. They have a top-notch brand. I think the stock is cheap."

After a strong third quarter, Smith upgraded E-Trade's stock to a strong buy on Oct. 20, but since then, it has fallen 22 percent.

The irony in all this is that the pure daytraders are making money in this market. Volatility is up, which gives them more opportunities to get the prices they want. Daytrading shops report strong business: Their traders profit from short-selling as the market keeps falling.

But with the bigger online firms caught between a tailwind of rising volume and a headwind of fewer average trades per customer, they're stuck in the middle again.

COPYRIGHT Standard Media International
COPYRIGHT Gale Group

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