TRADESTATION GROUP INC - Annual Report: 2004 (Form 10-K)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

For the fiscal year ended December 31, 2004

or

For the transition period from              to             

Commission file number: 0-31049

TradeStation Group, Inc.

(Exact name of registrant as specified in its charter)

954-652-7000

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, par value $.01 per share

(Title of class)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (17 CFR 229.405) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K  x

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).    Yes  x    No  ¨

The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant on June 30, 2004, based upon the closing market price of the registrant’s common stock on The Nasdaq National Market on such date, was approximately $146,202,000.

The registrant had 41,857,654 shares of common stock, $.01 par value, outstanding as of February 28, 2005.

DOCUMENTS INCORPORATED BY REFERENCE

NONE.

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PART I

ITEM 1. BUSINESS

Overview and Recent Developments

TradeStation Group, Inc., a Florida corporation formed in 2000, is the successor company to a publicly-held trading software company that was formed in 1982. TradeStation Group is listed on The Nasdaq National Market under the symbol “TRAD.” TradeStation Securities, Inc. and TradeStation Technologies, Inc. are TradeStation Group’s two operating subsidiaries.

TradeStation Securities, a leading online brokerage firm serving the active trader and certain institutional trader markets, is the company’s principal operating subsidiary. TradeStation Securities is a registered broker-dealer and futures commission merchant, and a member of the National Association of Securities Dealers (“NASD”), New York Stock Exchange (“NYSE”), Securities Investor Protection Corporation (“SIPC”), National Futures Association (“NFA”), National Securities Clearing Corporation and the Depository Trust Company (together, the Depository Trust & Clearing Corporation or “DTCC”), Options Clearing Corporation (“OCC”), American Stock Exchange (“AMEX”), Archipelago Exchange (“ArcaEx” or “ARCX”), Boston Options Exchange (“BOX”), Chicago Board Options Exchange (“CBOE”), Eurex US, International Securities Exchange (“ISE”), Pacific Stock Exchange (“PCX”) and Philadelphia Stock Exchange (“PHLX”). TradeStation Securities’ business is also subject to the rules and requirements of the Securities and Exchange Commission (“SEC”), Commodity Futures Trading Commission (“CFTC”) and state regulatory authorities.

TradeStation Securities’ core brokerage service is the TradeStation electronic trading platform, which is focused on rule-based trading. The TradeStation electronic trading platform seamlessly integrates powerful strategy trading software tools, historical and streaming real-time market data, and “intelligent” direct-access order-routing and execution. Direct-access trading means, with respect to equities, equities options and futures transactions, direct Internet connections to electronic marketplaces. These include, for stocks and Exchange Traded Funds (ETF’s), electronic communication networks (ECN’s), ARCX, SuperDOT (for listed securities) and Nasdaq Market Center, (for Nasdaq and listed securities), for futures, electronic futures exchanges such as the Chicago Mercantile Exchange’s (CME’s) Globex and the Chicago Board of Trade’s (CBOT’s) eCBOT, and, for equities options, electronic options exchanges offered by the AMEX, BOX, CBOE, ISE, PCX and PHLX. In each of these electronic marketplaces, anonymous buyers and sellers participating on the network are matched, often instantaneously following the placement of their orders. In addition to strategy trading tools, real-time market data and direct-access order execution, the TradeStation electronic trading platform offers state-of-the-art advanced order placement functions, unique automated and manual order placement capabilities, and numerous advanced charting and analytics features. A formal patent application covering the TradeStation electronic trading platform has been filed with the United States Patent and Trademark Office.

In September 2004, TradeStation Securities commenced self-clearing of equities trades for its active trader client base. Clearing operations include the confirmation, settlement, delivery and receipt of securities and funds and record-keeping functions involved in the processing of securities transactions. As the clearing broker for its equities active trader client base,

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TradeStation Securities maintains custody and control over the assets in those clients’ accounts and provides the following back office functions: maintaining customer accounts; extending credit in a margin account to the customer; settling security transactions with the DTCC (and, for options, with the Options Clearing Corporation, in the near future); settling commissions and clearing fees; preparing customer trade confirmations and statements; performing designated cashier functions, including the delivery and receipt of funds and securities to or from the customer; possession or control of customer securities, safeguarding customer funds, transmitting tax accounting information to the customer and to the applicable tax authorities; and forwarding prospectuses, proxies and other shareholder information to customers.

By the end of 2004, TradeStation Securities had approximately 18,300 equities, futures and forex accounts, the vast majority of which were equities and futures accounts, as compared to approximately 12,300 accounts at the end of 2003. During the 2004 fourth quarter, TradeStation Securities’ brokerage customer account base averaged nearly 35,000 daily average revenue trades (often called “DARTs”), as compared to 26,500 during the 2003 fourth quarter. During 2004, the average TradeStation Securities account made approximately 550 revenue trades. As of December 31, 2004, the average account asset balance of an equities account was nearly $100,000 and the average asset balance of a futures account was over $20,000.

In 2004, we launched TradeStation 8 and, in February 2005, an updated version, TradeStation 8.1. TradeStation 8 and its update contain significant enhancements, including integrated direct-access options execution, automated execution of options strategies, an enhanced options analysis window, market depth data for options, extended historical data for forex, cancel/replace stop market orders, the ability to back-test and automate strategies that monitor and act upon intra-bar events, and several other order execution, charting and market data enhancements.

On March 7, 2005, in Barron’s magazine’s annual ratings of online brokerage firms, TradeStation Securities, along with five other online brokerage firms, received the highest rating given—4 ¹/2 stars. In 2004 and 2003, Barron’s named TradeStation Securities Best Broker for Active Traders (a category not used in the 2005 ratings). In the Technical Analysis of Stocks and Commodities magazine Readers’ Choice Awards published February 23, 2005, TradeStation Securities was named, for the first time, Best Stock Brokerage, over competitors that included Ameritrade, Charles Schwab, E*Trade, Fidelity Brokerage, HarrisDirect, Scottrade, and TD Waterhouse, and, also for the first time, Best Futures Brokerage, over competitors that included Lind-Waldock, Man Futures, Refco and Rosenthal Collins. TradeStation Securities was also named in Stocks & Commodities magazine, for the third year in a row, best Direct Access Stock Brokerage, best Direct Access Futures Brokerage, best Institutional Platform, and best Professional Platform, over competitors that included Bloomberg, Reuters, Schwab’s CyberTrader, Refco and Man Futures.

We also provide via our technologies subsidiary, TradeStation Technologies, subscription services. The subscription version of TradeStation is an institutional-quality service that offers strategy trading software tools that generate real-time buy and sell alerts based upon the subscriber’s programmed strategies, but does not include order execution. Subscribers are charged a monthly subscription fee. The TradeStation trading software platform was named, for the second year in a row, best Subscription Internet Analytical Platform in the Technical Analysis of Stocks and Commodities magazine Readers’ Choice Awards published February 23, 2005, as well as, for the first time, best Options Analysis Software, best Trading Systems-Stocks, best Trading Systems-Futures, and best Trading Systems-Options, and TradeStation Technologies’ support Web site (which is now part of TradeStation Securities’ Web-based customer support center) was named best Trading Centers, Schools, Training.

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Our principal executive offices are located in The TradeStation Building, 8050 S.W. 10^th Street, Suite 4000, Plantation, Florida 33324, and our telephone number is (954) 652-7000.

THIS REPORT (PARTICULARLY “ITEM 1. BUSINESS” AND “ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS”) CONTAINS STATEMENTS THAT ARE FORWARD-LOOKING WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. SEE “ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – ISSUES, UNCERTAINTIES AND RISK FACTORS.”

Industry Background

Active Trader Market

The active trader market is usually defined as retail individuals, which include intra-day or day traders, semi-professionals, active “self-directed” traders, people who trade for themselves as a full-time or part-time business endeavor, or any other individual that trades much more actively than the typical online trading account. An active trader has historically been defined as one who trades a minimum of 10 times per month. The average TradeStation brokerage account trades four to five times that number.

The vast majority of active traders are believed to be with “traditional” online brokerage firms (e.g., Ameritrade, E*Trade, Fidelity, Schwab, T.D. Waterhouse, etc.). It is generally accepted in the online brokerage industry that 5% to 10% of each large online brokerage firm’s customer base consists of active traders. Nearly all of the large online brokerage firms have tried over recent years to acquire direct-access firms or technology, and more sophisticated trading analysis platforms, in order to retain and grow this most valuable segment of their customer bases. According to data and reports published over the last several years, there are estimated to be more than 20 million online accounts, and direct-access trading accounts have grown and have accounted for a higher percentage of trading activity of both Nasdaq and listed securities. Based on industry articles published in recent years, it appears that the majority of all order flow – both listed and Nasdaq – is handled electronically. Active traders are generally believed to account for the majority of online daily trades and have larger account asset balances (under current regulations, a minimum account balance of $25,000 is required for very active traders). In the 2004 fourth quarter, the average account asset balance of a TradeStation Securities equities account was nearly $100,000.

We believe an online brokerage focused on active traders, in order to maximize its potential for successful market penetration, needs to deliver:

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TradeStation Securities offers each of the above-mentioned features.

Institutional Trader Market

We see the institutional trader market, as it relates to potential customer relationships for direct-access brokerage firms like TradeStation Securities, as hedge fund and money managers, commodity trading advisors and commodity pool operators, and registered investment advisers who use short-term trading strategies. According to recent estimates, there are approximately 7,000 hedge funds today, which are estimated to manage up to one trillion dollars of invested assets, and 8,000 registered investment advisors, which are estimated to manage more than $23 trillion of invested assets. Also, of the largest hedge fund complexes, those with over $1 billion in assets, a majority have funds or commodity pools sponsored, operated or advised by CFTC-registered commodity trading advisors and/or commodity pool operators. The CFTC recently reported that there are approximately 3,250 commodity pools and more than 2,000 registered commodity pool operators.

Many believe that buy side institutional traders have become less and less pleased with Wall Street (traditional sell side brokerage firms) and are moving, to one degree or another, towards using direct-access execution of their trading decisions. The biggest concern institutional traders are said to have today is that the cost of their trades – not just commissions, but mainly the costs that result from adverse market movement caused by large block trades – is no longer acceptable. Accordingly, these institutional traders are looking for systems that provide the fastest execution at the best prices possible. The fastest execution is provided by robust direct-access technology, and the “best prices possible” means an exhaustive list of execution venues to ensure maximum access to liquidity through intelligent order routing. It also means that the direct-access platform offers “stealthy” execution of large block orders (anonymity) through advanced reserve order, hidden order, discretionary order and order pegging technology – technology that enables the trade to be completed with minimal market disturbance. These basics: (1) effective, robust, speedy execution; (2) full liquidity (access to all major electronic marketplaces); (3) advanced order capabilities; and (4) intelligent order routing, must be in place before an institutional fund manager or other institutional buy side trader will consider using a direct-access brokerage firm. These are all strengths of the TradeStation electronic trading platform.

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Other features and services that are important to many buy side institutional traders include sophisticated decision-support front ends, automated trading functionality, intuitive, manual one-click order placement, advanced portfolio/basket trading, multiple account trade allocation, a detailed, flexible order management/portfolio management system (or the ability to integrate their management systems with the direct-access firm’s order execution software), and a broad scope of assets (stocks, options, futures and forex). TradeStation contains, arguably, the best decision-support and automated trading and manual order placement functionality on the market, list/basket trading, multiple account trade allocation, and state-of-the-art direct-access execution services for stocks, options and futures trading, and advanced analytics and electronic execution for forex trading, and is working to complete more advanced portfolio/basket trading features and new order and risk management system compatibilities and features.

Products and Services

Overview – TradeStation

Our main product/service offering is the TradeStation electronic trading platform, complete with direct-access order execution services, for institutional, professional and serious, active individual traders. A formal patent application covering what we believe to be the unique, powerful technology of TradeStation is pending. TradeStation does not provide investment or trading advice or recommendations, or recommend the use of any particular strategy, but rather enables the trader to design, test, optimize and automate his own, custom trading strategies. TradeStation is a registered trademark in the United States, Australia, Canada, the European Union, Indonesia, Korea, Singapore, South Africa and Taiwan.

In addition to offering the TradeStation electronic trading platform to the brokerage customers of our TradeStation Securities subsidiary, we offer, through our TradeStation Technologies subsidiary, TradeStation subscriptions. The difference between the TradeStation electronic trading platform and the TradeStation subscription service is that the subscription service does not include order execution or account management capabilities.

TradeStation has, since its initial release as a strategy trading software program in 1991, been our flagship product. From 1996 until October 2001 it was marketed worldwide to institutional traders on a monthly subscription basis by Telerate, Inc., as a premium tool for the Telerate data feed service. It has also served, and continues to serve, as a strategy trading platform for numerous third-party software applications. Its state-of-the-art technology empowers the trader to design and develop a trading strategy based upon the trader’s objective rules and criteria, test the potential profitability of that trading strategy against historical data, and then computer-automate it to monitor the applicable market and alert the trader in real-time when the criteria of the trading strategy have been met and an order should, therefore, be placed. The principal features of TradeStation that enable the trader to design and develop trading strategies are EasyLanguage and the PowerEditor. EasyLanguage is a proprietary computer language we developed consisting of English-like statements and trading terms which can be input by the trader to describe particular objective rules and criteria. The PowerEditor is a compiler of EasyLanguage statements that provides the trader with considerable flexibility to modify and combine different trading rules and criteria, which ultimately result in the design of the trader’s trading strategies. EasyLanguage and PowerEditor are also registered trademarks.

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Brokerage Services

TradeStation Securities’ principal offering today is online brokerage services, covering equities (principally stocks and ETFs), equities options, futures (including futures options) and forex transactions, through the TradeStation electronic trading platform. TradeStation Securities’ targeted customer base for brokerage services includes active individual, professional and institutional traders, including hedge fund and money managers and investment advisors who use short-term trading strategies. In addition to providing direct-access online services through the TradeStation electronic trading platform, the brokerage firm offers personal support services by its registered trade-desk representatives who execute customers’ orders through direct-access order execution systems if the customer is for some reason unable or unwilling to place the order using his or her own computer.

Having a “direct-access” order execution system, whether accessed directly by the brokerage customer through the TradeStation electronic trading platform or by a TradeStation Securities broker on behalf of the brokerage customer, means that both the online services and the firm’s trading desks are directly connected to stock, futures and options exchanges and ECNs. ECNs, such as Instinet (INCA)/Island (ISLD) and Bloomberg (BTRD), and electronic equities exchanges such as ARCX, Nasdaq Market Center, which now includes BRUT, and SuperDOT (listed securities), directly match anonymous buyers and sellers participating on the network. This system often results in the simplest, most direct and speediest execution of orders for equity securities at the best available price. With respect to electronically-traded futures contracts, the TradeStation electronic trading platform is directly connected to the CME (Globex), CBOT (eCBOT) and OneChicago. With respect to pit-traded futures contracts, TradeStation is directly connected to its futures clearing organization’s online execution system which sends the order directly to the trading pit. Approximately 98% of the company’s futures trades are on the electronic futures exchanges. With respect to options, the TradeStation electronic trading platform is directly connected to every major options exchange that offer electronic trading, including AMEX, BOX, CBOE, ISE, PCX and PHLX. With respect to forex deals, the TradeStation electronic trading platform is directly connected to a third-party forex dealer’s online deal system, which then electronically places the forex orders.

TradeStation Securities self-clears for its active trader equity securities accounts. Institutional accounts for equity securities, and all futures accounts, currently are carried on a “fully disclosed” basis by the brokerage’s clearing agents. TradeStation Securities executes its customers’ securities and futures transactions on an agency basis only, as opposed to a principal basis. That is, it acts as the agent for its customers directly in the market. When brokerage firms perform transactions on a principal basis, they are permitted to accept a customer’s order to purchase, purchase the securities in the market for the brokerage firm, and then sell the securities to the customer. TradeStation Securities does not do this. It always charges only an agreed-upon commission and never earns income from marking up or marking down its customers’ securities or futures transactions. For forex deals, a forex dealer affiliated with our futures clearing agent acts as principal/counterparty for, and clears, all deals with the company’s forex customers.

For financial information concerning the brokerage services segment of our operations, see MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS and Note 18 of Notes to Consolidated Financial Statements – SEGMENT AND RELATED INFORMATION.

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Software Products and Services

In December 2000, we launched the TradeStation electronic subscription service. The TradeStation electronic subscription service includes our award-winning strategy trading features and functions, streaming real-time charts and quotes, streaming news, state-of-the-art analytical charting, and all other features included in the TradeStation electronic trading platform other than trade order placement and other trading or brokerage-related features or services. During 2004, the TradeStation electronic subscription service was offered to new subscribers at the monthly rate of $199.95 and to legacy customers who had “upgraded” at a monthly rate of $129.95. We evaluate our approach to subscription fee pricing on an ongoing basis, which may result in different price offerings during 2005. TradeStation (both as a subscription service and as a brokerage account trading platform) also offers our OptionStation and RadarScreen functions and features. OptionStation, also an award-winning technology, is an options trading analysis product for equities, index and futures options that enables traders to explore options trading strategies. RadarScreen enables traders to scan up to hundreds or thousands, depending upon the data service and computer hardware used, of equities or other securities to identify potential buying or selling opportunities based upon the traders’ own trading strategies.

In the 2001 fiscal year, our software products and services operations were responsible for the majority of our revenues. However, we ceased marketing our legacy software products in May 2000 and ceased marketing our subscription software services in December 2000. Accordingly, in 2002, 2003 and 2004, and, we expect, for the foreseeable future, our brokerage operations produced and should continue to produce the majority of our revenues. In 2002, 2003 and 2004, brokerage revenues accounted for approximately 80%, 85% and 86%, respectively, of our total revenues, and subscription fees accounted for approximately 14%, 12% and 11%, respectively, of our total revenues over that three-year period.

For financial information concerning the software products and services segment of our operations, see MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS and Note 18 of Notes to Consolidated Financial Statements – SEGMENT AND RELATED INFORMATION.

Sales and Marketing

Our marketing in 2004 consisted principally of print advertising in Active Trader, Futures, SFO, and Technical Analysis of Stocks & Commodities magazines, direct mail and e-mail, sales seminars, and our Web sites, though, in the 2004 fourth quarter, after engaging an advertising agency, we began a limited television advertising campaign, which has continued. The mix and frequency of television, print, Web-site, direct-mail and in-person marketing methods we use to try to achieve results will likely be continually modified as we test such methods and mixtures and analyze and interpret the results.

Approximately 12% of our revenues were derived from customers outside of the United States for the year ended December 31, 2004. Less than 10% of our revenues were derived from customers outside of the United States for the years ended December 31, 2003 and 2002. International revenues are collected in U.S. dollars. We conduct no marketing, sales or other operations, and maintain no assets, outside of the United States.

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Strategic Relationships

Clearing Services. Our brokerage’s clearing services for institutional securities accounts, and for all futures accounts, are currently provided by Bear, Stearns Securities Corp. and R.J. O’Brien & Associates, Inc., respectively, pursuant to industry-standard clearing agreements.

Forex Deal Services. Our forex deal services are currently provided through an arrangement with R.J. O’Brien Foreign Exchange Inc., an affiliate of our futures clearing agent. Forex customers design, test, optimize and automate their forex strategies using TradeStation, then, when a deal order is to be placed, the customer connects directly to the online deal system that R.J. O’Brien Foreign Exchange licenses from a third-party software system vendor, and places the order. R.J. O’Brien Foreign Exchange is the counterparty/principal for each forex deal.

Technology Development

We believe that our success depends, in large part, on our ability to offer unique, Internet-based trading technologies with state-of-the-art order execution technologies, and continuously enhance those technologies, as well as develop and implement well-designed and user-friendly Web sites. To date, we have relied primarily on internal development of our products and services. We currently perform all quality assurance and develop user education and other training materials internally. In 2004, 2003 and 2002, technology development expenses were approximately $7.4 million, $7.1 million and $8.9 million, respectively. As of December 31, 2004, our technology development team was comprised of 76 people, as compared to 74 as of December 31, 2003, a 3% increase.

We view our technology development cycle as a four-step process to achieve technological feasibility. The first step is to conceptualize in detail the defining features and functions that we believe our targeted market requires from the product or service, and to undertake a cost-benefit analysis to determine the proper scope and integration of such features and functions. Once the functional requirements of the product or service have been determined, the second step is to technically design the product or service. The third step is the detailed implementation, or engineering, of this technical design. The fourth step is rigorous quality assurance testing to ensure that the final product or service generally meets the functional requirements determined in the first step. Several refinements are typically added and tested in the quality assurance phase of development. Once this process is completed, technological feasibility has been achieved and the working model is available for release to our customers.

The market for strategy trading software tools, streaming real-time market data and news services, and online order execution services is characterized by: rapidly changing technology; evolving industry standards in computer hardware, programming tools and languages, operating systems, database technology and information delivery systems; changes in customer requirements; and frequent new product and service introductions and enhancements, as well as technical consolidation of products and services. Our success will depend, in part, upon our ability to develop and maintain competitive technologies and to develop and introduce new products, services and enhancements in a timely and cost-effective manner that meets changing conditions such as evolving customer needs, existing and new competitive product and service offerings, emerging industry standards and changing technology. There can be no assurance that we will be able to develop and market, on a timely basis, if at all, products, services or

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enhancements that respond to changing market conditions or that will be accepted by customers. Any failure by us to anticipate or to respond quickly to changing market conditions, or any significant delays in the introduction of new products and services or enhancements, could cause customers to delay using, or decide against the use of, our products and services and could have a material adverse effect on our business, financial condition and results of operations.

Customer Services and Support and Training

We provide customer services and support and product-use training in the following ways:

Customer Services and Support. Telephone customer service is provided to brokerage customers through a trained customer service team. Technical support to subscription and brokerage customers who use the TradeStation electronic platform is provided by a technical support team. Advanced EasyLanguage consulting services (services that technically assist customers in the use of EasyLanguage to write the customers’ own trading strategies) are available from internal resources and from unaffiliated, independent EasyLanguage consultants. A substantial amount of technical support information is also provided on our Web sites.

Product-use Training. We consider user education important to try to help our customers increase their abilities to use our products and services fully and effectively. The majority of our training materials consist of extensive online documentation and technical assistance information on our Web sites, including online tutorials, as well as in-person training seminars and an annual users conference, so that our customers may learn to use and take full advantage of the sophisticated technology of the TradeStation electronic trading platform. The TradeStation.com Support Center includes access to an interactive community for active traders who engage or have interest in the development, testing and use of objective trading strategies. The community provides numerous discussion forums on a variety of topics related to strategy development and technical trading as well as TradeStation product and service features, articles about trading from industry leaders, and a “library” of strategy indicators, rules and components written in our proprietary EasyLanguage, many of which are donated by third parties.

Competition

The market for online brokerage services is intensely competitive and rapidly evolving, and there appears to be substantial consolidation in the industry in three different ways. First, there has been over the past several years and continues to be consolidation of three types of services that traditionally were offered separately: online brokerage services; real-time market data services; and trading analysis software products and services. With the TradeStation electronic trading platform, we have embraced this consolidation by offering all three of these services in a fully-integrated, seamless manner. Second, we believe consolidation is beginning to occur in the four major online execution markets for active traders – equities, equities options, futures and forex – meaning that, contrary to specializing in offering services for only one of those market instruments, more and more firms are offering or plan to offer three or four of those services. With our offering of online trading services for all four of these markets, we have embraced this consolidation as well. Third, as a result of price pressure and competition over the last three years, we believe barriers of entry to, and the sustainability of, small online brokerage businesses have become more challenging. As a result, many small online brokerage firms have, over the past few years, failed or been acquired by larger firms that are seeking to increase the size of

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their account base to help increase their ability to compete on price. We believe we have advantages in this area. The uniqueness of our trading technology enables us to charge value-added fees to our customers, and the scalability and efficiencies made possible by that technology, coupled with the frequent trading activity of our customer base, enable us to grow our daily average revenue trade activity with minimal increases in our fixed costs.

We believe that competition, including price competition, as well as consolidation, will substantially increase and intensify in the future. We believe our ability to compete will depend upon many factors both within and outside our control, including: price pressure; the timing and market acceptance of new products and services and enhancements developed by us and our competitors; our ability to design and support efficient, materially error-free Internet-based systems; market conditions, such as recession; the size of the active trader market today and in the future; the extent to which institutional traders are willing to use direct-access brokerage services offered by firms that have traditionally served mostly retail customers; product and service functionality; data availability and cost; clearing costs; ease of use; reliability; customer service and support; and sales and marketing decisions and efforts.

We face direct competition from several publicly-traded and privately-held companies, principally online brokerages, including providers of direct-access order execution services. Our competitors include the many online brokerages currently active in the United States, including Ameritrade, Banc of America Investment Services (formerly Quick & Reilly), Charles Schwab & Co. (including CyberTrader), E*Trade Securities, Fidelity Brokerage Services, HarrisDirect (formerly CSFB Direct), Instinet Corporation (a Reuters subsidiary, and an ECN that also provides direct-access brokerage service), Interactive Brokers, JPMorgan, Merrill Lynch Direct, OptionsXpress, Redi Products, a division of Spear, Leeds & Kellogg (which is owned by Goldman Sachs), Scottrade Financial Services, TD Waterhouse Investor Services, Terra Nova Trading and thinkorswim. Those brokers currently serve, in the aggregate, more than 90% of existing online accounts, and many are focusing on attracting and retaining active traders. Many online brokerages currently claim to offer direct-access service. Even though we are rated as one of the best online brokerage firms in the United States, there can be no assurance that we will be able to maintain such ratings, be rated that highly in the future, compete effectively with our competitors, adequately educate potential customers about the benefits our products and services provide, or continue to offer such products and services.

Many of our existing and potential competitors, which include large, online discount and traditional national brokerages, and financial institutions that are focusing more closely on online services, including direct-access services for active traders, have longer operating histories, significantly greater financial, technical and marketing resources, greater name recognition and a larger installed customer base than do we. Further, there is the risk that larger financial institutions which offer online brokerage services as only one of many financial services may decide to use extremely low commission pricing as a “loss leader” to acquire and accumulate customer accounts and assets to derive interest income and income from their other financial services. We do not offer other financial services, and have no plans to do so; therefore, such pricing techniques, should they become common in our industry, could have a material, adverse effect on our results of operations, financial condition and business model.

Generally, competitors may be able to respond more quickly to new or emerging technologies or changes in customer requirements or to devote greater resources to the

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development, promotion and sale of their products and services. There can be no assurance that our existing or potential competitors will not develop products and services comparable or superior to those developed and offered by us or adapt more quickly to new technologies, evolving industry trends or changing customer requirements, or that we will be able to timely and adequately complete the implementation, and appropriately maintain and enhance the operation, of our business model. Increased competition could result in price reductions, reduced margins, failure to obtain any significant market share, or loss of market share, any of which could materially adversely affect our business, financial condition and results of operations. There can be no assurance that we will be able to compete successfully against current or future competitors, or that competitive pressures faced by us will not have a material adverse effect on our business, financial condition and results of operations.

Intellectual Property

Our success is and will be heavily dependent on proprietary software technology, including certain technology currently in development. We view our software technology as proprietary, and rely, and will be relying, on a combination of copyright, trade secret and trademark laws, nondisclosure agreements and other contractual provisions and technical measures to establish and protect our proprietary rights. We have a formal patent application pending for the TradeStation trading platform, but software patents, particularly Internet-related software patents, are increasingly difficult to obtain, and there can be no assurance that we will obtain a patent or patents broad enough in scope to have value, or obtain a patent at all. We have registered copyright rights in our EasyLanguage dictionary and documentation and TradeStation software.

We have obtained trademark registrations for the TradeStation mark in the United States, Australia, Canada, the European Union, Indonesia, Korea, Singapore, South Africa and Taiwan. We have obtained registrations for the OptionStation mark in the United States, Canada and the European Union. We have obtained registrations in the United States for the marks ActivityBar, EasyLanguage, PositionGraphs, PowerEditor, ProbabilityMap, ProSuite, RadarScreen, Test Before You Trade and other marks.

We use an online subscription agreement for our Internet trading software and data services between TradeStation Technologies and each of the users (whether the users are brokerage customers or monthly subscribers) in order to protect our copyrights and trade secrets and to prevent such users from commercially exploiting such copyrights and trade secrets for their own gain. Since these licenses are not physically signed by the licensees, it is possible their enforceability is limited under certain state laws and the laws of many foreign jurisdictions.

Despite our efforts to protect our proprietary rights, unauthorized parties copy or otherwise obtain, use or exploit our software or technology independently. Policing unauthorized use of our software technology is difficult, and we are unable to determine the extent to which piracy of our software technology exists. Piracy can be expected to be a persistent problem, particularly in international markets and as a result of the growing use of the Internet. In addition, effective protection of intellectual property rights may be unavailable or limited in certain countries, including some in which we may attempt to expand sales efforts. There can be no assurance that the steps taken by us to protect our proprietary rights will be adequate or that our competitors will not independently develop technologies that are substantially equivalent or superior to ours.

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There has been substantial litigation in the software industry involving intellectual property rights. We do not believe that we are infringing, or that any technology in development will infringe, the intellectual property rights of others. However, there can be no assurance that infringement claims would not have a material adverse effect on our business, financial condition and results of operations.

To the extent that we acquire or license a portion of the software or data included in our products or services from third parties (some data is licensed from third parties), or market products licensed from others generally, our exposure to infringement actions may increase because we must rely upon such third parties for information as to the origin and ownership of such acquired or licensed software or data technology. Software patent infringement cases in financial service industries are becoming more frequent, and we may be subject to litigation to defend against claimed infringement of the rights of others or to determine the scope and validity of the intellectual property rights of others. In the future, litigation will likely be necessary to establish, define, enforce, defend and protect patents, trade secrets, copyrights, trademarks and other intellectual property rights. Any such litigation would likely be costly and divert management’s attention, which could have a material adverse effect on our business, financial condition and results of operations. Adverse determinations in such litigation could result in the loss of proprietary rights, subject us to significant liabilities, require us to seek licenses from third parties, which could be expensive, or prevent us from selling our products or services or using our trademarks, any one of which could have a material adverse effect on our business, financial condition and results of operations.

Government Regulation

Our brokerage subsidiary, TradeStation Securities, is subject to extensive securities and futures industry regulation under both federal and state laws as a broker-dealer with respect to its equities and equities options business and as a futures commission merchant with respect to its futures and forex business. Broker-dealers and futures commission merchants are subject to regulations covering all aspects of those businesses, including: sales methods; trade practices; use and safe-keeping of customers’ funds and securities; clearing, processing and settlement of trades, and arrangements with clearing houses, exchanges and clearing corporations; capital structure; cash deposit or escrow requirements (or their equivalent); record keeping; conduct of directors, officers and employees; and supervision. To the extent TradeStation Securities solicits orders from customers or makes investment recommendations, it is subject to additional rules and regulations governing, among other things, sales practices and the suitability of recommendations to its customers.

TradeStation Securities’ mode of operation and profitability may be directly affected by: additional legislation; changes in rules promulgated by the SEC, NASD, NYSE, CFTC, NFA, the Board of Governors of the Federal Reserve System, DTCC, OCC, various securities and futures exchanges, and other self-regulatory associations and organizations; and changes in the interpretation or enforcement of existing rules and laws, particularly any changes focused on online brokerages that target an active trader customer base.

With respect to active trading, the NASD has adopted rules that require firms to provide customers with a risk disclosure statement about active trading. Further, the NASD and NYSE’s

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margin rules impose more restrictive requirements for “pattern” active traders. Governmental concern is focused in two basic areas: that the customer has sufficient trading experience and that the customer has sufficient risk capital to engage in active trading. A minimum equities account balance of $25,000 is required. TradeStation Securities’ customer account documentation specifies that being a brokerage customer of TradeStation Securities is only for traders who have experience in active trading, are willing to risk considerable amounts of capital (at least $50,000), and are interested in engaging in high-risk, short-term, speculative trading activity. We believe our brokerage firm’s minimum account opening requirements, as well as the extensive user education documentation and tutorials offered on our Web site, are consistent with both the letter and the spirit of current rules and regulations concerning active trading.

The SEC, NASD, NYSE, CFTC, NFA and other self-regulatory associations and organizations and state securities commissions can censure, fine, enjoin, suspend, expel or issue cease-and-desist orders to a broker-dealer or futures commission merchant or any of its officers or employees.

Marketing campaigns by TradeStation Securities to bring brand name recognition to its services and to promote the benefit of those services, such as the TradeStation electronic trading platform and its various features, are regulated by the NASD and NFA, and all marketing materials must be reviewed by an appropriately-licensed TradeStation Securities principal prior to release, and must conform to standards articulated by the SEC, NASD and NFA. The NASD or NFA may request that revisions be made to marketing materials, and can impose certain penalties for violations of its advertising regulations, including censures or fines, a requirement of advance regulatory approval of all advertising, the issuance of cease-and-desist orders, and the suspension or expulsion of a broker-dealer or futures commission merchant or any of its officers or employees.

The SEC, NASD, NYSE, CFTC, NFA, DTCC and OCC and various other regulatory associations and organizations have stringent rules with respect to the maintenance of specific levels of net capital or cash deposit requirements and reserves by securities broker-dealers and futures commission merchants. Net capital is the net worth of the regulated company (assets minus liabilities), less deductions for certain types of assets as well as other charges. If a firm fails to maintain the required net capital it must cease conducting business and, if it does not do so, it may be subject to suspension or revocation of registration by the SEC or the CFTC and suspension or expulsion by the NASD, NYSE or NFA, and it could ultimately lead to the firm’s liquidation.

TradeStation Securities is registered as a broker-dealer in every U.S. state and the District of Columbia, and is subject to regulation under the laws of those jurisdictions, including registration requirements and being subject to sanctions if a determination of misconduct is made.

TradeStation Securities is a member of the SIPC. SIPC provides protection of up to $500,000 for each securities account brokerage customer, subject to a limitation of $100,000 for cash balances, in the event of the financial failure of a broker-dealer. For securities brokerage accounts the custody and trade clearing of and for which are handled by TradeStation Securities, an excess securities bond through HSBC Insurance Brokerage Limited, as agent of Lloyd’s of London, provides protection for any loss of securities and/or cash in excess of primary SIPC

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protection, up to $200 million in the aggregate (and up to $24.5 million per any one account). Based upon the asset size per account and in the aggregate of TradeStation Securities’ securities account customer base as of the date of this report, this excess-SIPC protection, combined with primary SIPC protection, should be more than adequate to cover the loss of 100% of those customer assets in the very unlikely event that TradeStation Securities experienced financial failure and all customer assets were somehow lost. To the extent TradeStation Securities clears its securities brokerage transactions through Bear, Stearns Securities Corp. (which, currently, it does only for institutional accounts), Bear, Stearns has obtained an excess securities bond that provides protection for any loss of securities and/or cash in excess of the primary SIPC protection. Neither SIPC nor excess-SIPC coverage applies to fluctuations in the market value of securities or any losses other than those directly caused by the financial failure of the broker-dealer, or to futures or forex accounts.

It is possible that other federal or state agencies will attempt to regulate our current and planned online and other electronic service activities with rules that may include compliance requirements relating to record keeping, data processing, other operation methods, privacy, pricing, content, and quality of goods and services as the market for online commerce evolves. Given the continuing growth of the electronic commerce market, federal or state authorities may enact additional laws, rules or regulations, not only with respect to online brokerage services, but to other online services we provide or may in the future provide. Such laws, rules and regulations, if and when enacted, could have a material adverse effect on our business, financial condition, results of operations and prospects.

Employees

As of December 31, 2004, we had 256 full-time equivalent employees, consisting of 29 in clearing operations, 76 in technology development (including software engineering, product management, user education and quality assurance), 109 in sales and marketing relating to brokerage services, subscriptions and software products (including 39 in sales, 16 on the trading desk, 42 in customer service and software support and 12 in marketing and fulfillment), and 42 in general and administrative (including executive management, finance, information technology services, compliance and human resources). Our employees are not represented by any collective bargaining organization, and we have never experienced a work stoppage and consider our relations with our employees to be good.

Our future success depends, in significant part, upon the continued service of our key senior management and technology development personnel. The loss of the services of one or more of these key employees could have a material adverse effect on us. There can be no assurance that we will be able to retain our key personnel. Departures and additions of personnel, to the extent disruptive, could have a material adverse effect on our business, financial condition and results of operations.

Available Information

We offer access to our corporate TradeStation Group Web site via www.tradestation.com. We make available free of charge through our Web site this Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as

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amended, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. We also make available, through our Web site, statements of beneficial ownership filed by our directors, officers, shareholders who own more than 10% of our issued and outstanding capital stock, and others under Section 16 of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after such material is filed with, or furnished to, the Securities and Exchange Commission.

ITEM 2. PROPERTIES

We have a ten-year lease expiring in August 2012 (with two 5-year renewal options) that commenced in the summer of 2002 for an approximately 70,000 square-foot corporate headquarters in Plantation, Florida. Plantation is just west of Ft. Lauderdale, Florida (Broward County). This headquarters consolidated the personnel and operations of our former Miami and Boca Raton offices.

Our brokerage operations were formerly headquartered from 11,800 square feet of office facilities in Boca Raton, Florida pursuant to a lease that expires in February 2007. All of this space is currently being subleased through February 2007 at lease rates significantly lower than the rates we pay.

Our technologies subsidiary has an approximately 13,500 square foot leased facility in Richardson, Texas from which certain technology development and technical operations are conducted. A portion of those facilities serve as a branch office for TradeStation Securities. That lease expires July 31, 2007. We also lease exclusive rack space for our data server farms at three sites, one in Richardson, Texas (expiring in April 2006), one in Chicago, Illinois (expiring in August 2006), and one in Miami, Florida (expiring in May 2005).

We believe that our facilities are adequate to support our current operations and that, if needed, we will be able to obtain suitable additional facilities on commercially reasonable terms.

ITEM 3. LEGAL PROCEEDINGS

On September 5, 2003, Datamize, Inc., a Wyoming corporation, filed an Original Complaint for Patent Infringement against nine defendants, including TradeStation Securities, all of whom offer online securities trading services. The other defendants named were Fidelity Brokerage Services, Scottrade, Interactive Brokers Group, Instinet, Charles Schwab, CyberTrader, E*Trade Securities and Terra Nova Trading. The complaint was filed in the United States District Court, Eastern District of Texas. The complaint alleged that the online trading platforms and services the defendants offer to their customers infringes United States Patent No. 6,460,040 issued to Datamize on October 1, 2002. In December 2004, all claims against TradeStation Securities were settled by a settlement and license agreement between TradeStation Securities and Datamize for a lump-sum royalty payment which covers all uses since patent issuance and for the remaining years of the patents in question. The amount of the royalty attributable to the 2004 fourth quarter was not, and the amount attributable to any future period will not be, material to our consolidated financial position, results of operations or cash flows.

Three lawsuits have been filed by former principal owners of onlinetradinginc.com corp. (the predecessor of TradeStation Securities) against TradeStation Group, certain of its directors and

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executive officers and certain family partnerships owned by two of the executive officers. On July 25, 2003, Benedict S. Gambino, from whom the company, as of October 18, 2002, purchased 2,417,000 shares of its common stock in a private transaction, filed a lawsuit against the company and three of its executive officers, William R. Cruz, Ralph L. Cruz and Marc J. Stone, in the Circuit Court of Broward County, State of Florida. This lawsuit’s allegations include violation of the Florida Securities and Investor Protection Act, common law fraud, negligent misrepresentation, breach of fiduciary duty and breach of contract. On August 18, 2003, Andrew A. Allen Family Limited Partnership (owned and controlled by Andrew A. Allen), from whom the company, as of November 26, 2002, purchased 1,000,000 shares of its common stock in a private transaction, filed a lawsuit against the same defendants in the same court. This lawsuit’s allegations include violation of the Florida Securities and Investor Protection Act, common law fraud, breach of fiduciary duty, negligent misrepresentation and fraudulent inducement. On August 28, 2003, Farshid Tafazzoli and E. Steven zum Tobel filed a lawsuit against the company, the Cruzes, family partnerships owned and controlled by the Cruzes, Mr. Stone, Charles Wright and David Fleischman in the Circuit Court of Miami-Dade County, State of Florida. Mr. Tafazzoli’s claims relate to his family partnership’s sale, as of May 1, 2002, of 3,000,000 shares of Company common stock to family partnerships owned by William and Ralph Cruz, and Mr. zum Tobel’s claims relate to his family partnership’s sale, as of May 3, 2002, of 133,942 shares of Company common stock to Charles Wright. This lawsuit’s allegations include violation of the Florida Securities and Investor Protection Act, common law fraud and breach of fiduciary duty. Each of the three lawsuits seeks rescission of the share purchases and/or compensatory damages, plus interest, costs and attorneys’ fees. All three cases are in the discovery phase of litigation, and we continue to believe all of the claims in all three cases are baseless.

TradeStation Securities is also engaged in routine litigation or other dispute resolution proceedings, such as arbitration, incidental to, and part of the ordinary course of, its business (three claims in pending arbitrations seek, in the aggregate, tens of millions of dollars of actual and punitive damages).

While no assurances can be given, we do not believe that the ultimate outcome of any of the above legal matters or claims will result in a material adverse effect on our consolidated financial position, results of operations or cash flows.

We decided, as of June 1, 2002, to no longer carry errors or omissions insurance that covers third-party claims made by brokerage customers or software subscribers as a result of alleged human or system errors, failures, acts or omissions. This decision was made based upon our assessment of the potential risks and benefits, including significant increases in premium rates, deductibles and coinsurance amounts, reductions in available per occurrence and aggregate coverage amounts, and the unavailability of policies that sufficiently cover the types of risks that relate to our business.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the fourth quarter of 2004.

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PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Common Stock Information

Our common stock, par value $.01 per share, is listed on The Nasdaq National Market under the symbol “TRAD.” The high and low closing sales prices based on actual transactions on The Nasdaq National Market during each of the quarters presented are as follows:

As of February 28, 2005, there were 93 holders of record of our common stock, and, based upon information previously provided to us by depositories and brokers, we believe there are more than 7,000 beneficial owners.

Dividend Policy

We intend to retain future earnings to finance our growth and development and therefore do not anticipate paying any cash dividends in the foreseeable future. Payment of any future dividends will depend upon our future earnings and capital requirements and other factors we consider appropriate. We did not distribute any dividends during the years ended December 31, 2004, 2003, or 2002.

Recent Sales of Unregistered Securities

During the three months ended December 31, 2004, we did not issue or sell any unregistered securities. On January 3, 2005, we issued to 224 employees (including 3 executive officers) options to purchase an aggregate of approximately 526,000 shares of common stock. Such options vest ratably in annual increments over a five-year period and are exercisable at $7.11 per share, which was the fair market value (as defined in our Incentive Stock Plan) of our common stock on the date the options were granted. All of the options were granted under our Incentive Stock Plan in the ordinary course, and expire, if they remain unexercised, on the tenth anniversary of the date on which they were granted.

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All the foregoing options were issued by us in reliance upon the exemption from registration available under Section 4(2) of the Securities Act of 1933, as amended.

ITEM 6. SELECTED FINANCIAL DATA

The following selected consolidated financial data should be read in conjunction with, “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS,” and the Consolidated Financial Statements and Notes thereto included in this report. The Consolidated Statement of Operations Data presented below for the years ended December 31, 2004, 2003 and 2002, and the Consolidated Balance Sheet Data as of December 31, 2004 and 2003, have been derived from our Consolidated Financial Statements included on pages F-1 through F-31 of this report, which have been audited by Ernst & Young LLP, independent registered public accounting firm. The Consolidated Statement of Operations Data presented below for the years ended December 31, 2001 and 2000, and the Consolidated Balance Sheet Data as of December 31, 2002, 2001, and 2000, have been derived from audited financial statements not included in this report. See also Note 19 of Notes to Consolidated Financial Statements - UNAUDITED QUARTERLY FINANCIAL INFORMATION for quarterly financial information for fiscal years 2004 and 2003.

(Continued)

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This discussion should be read in conjunction with the Selected Financial Data and the Consolidated Financial Statements and Notes to Consolidated Financial Statements contained in this report.

Overview

TradeStation Group, Inc., a Florida corporation formed in 2000, is the successor company to a publicly-held trading software company that was formed in 1982. TradeStation Group is listed on The Nasdaq National Market under the symbol “TRAD.” TradeStation Securities, Inc. and TradeStation Technologies, Inc. are currently TradeStation Group’s two operating subsidiaries.

TradeStation Securities, a leading online brokerage firm serving the active trader and certain institutional trader markets, is the company’s principal operating subsidiary. TradeStation Securities is a registered broker-dealer and futures commission merchant, and a member of the NASD, NYSE, SIPC, NFA, DTCC, OCC, AMEX, ARCX, BOX, CBOE, Eurex US, ISE, PCX and PHLX. TradeStation Securities’ business is also subject to the rules and requirements of the SEC, CFTC and state regulatory authorities.

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In September 2004, TradeStation Securities commenced self-clearing of equities trades for its active trader client base. Clearing operations include the confirmation, settlement, delivery and receipt of securities and funds and record-keeping functions involved in the processing of securities transactions. As the clearing broker for its equities active trader client base, TradeStation Securities maintains custody and control over the assets in those clients’ accounts and provides the following back office functions: maintaining customer accounts; extending credit in a margin account to the customer; settling security transactions with the DTCC; settling commissions and clearing fees; preparing customer trade confirmations and statements; performing designated cashier functions, including the delivery and receipt of funds and securities to or from the customer; possession or control of customer securities, safeguarding customer funds, transmitting tax accounting information to the customer and to the applicable tax authorities; and forwarding prospectuses, proxies and other shareholder information to customers. In the 2004 fourth quarter (the first full quarter of self-clearing active trader equities accounts), brokerage revenues included increased interest income, net of interest expense, and clearing costs were reduced, which, in the aggregate, represented approximately a $1.5 million improvement to income from operations from the 2004 third quarter.

By the end of 2004, TradeStation Securities had approximately 18,300 equities, futures and forex accounts, the vast majority of which were equities and futures accounts, as compared to approximately 12,300 accounts at the end of 2003. During the 2004 fourth quarter, TradeStation Securities’ brokerage customer account base averaged nearly 35,000 DARTs, as compared to 26,500 during the 2003 fourth quarter. As of December 31, 2004, the average account asset balance of an equities account was nearly $100,000 and the average asset balance of a futures account was over $20,000.

We also provide via our technologies subsidiary, TradeStation Technologies, subscription services. The subscription version of TradeStation is an institutional-quality service that offers strategy trading software tools that generate real-time buy and sell alerts based upon the subscriber’s programmed strategies, but does not include order execution. Subscribers are charged a monthly subscription fee.

Results of Operations

For the three years ended December 31, 2004, we operated in two principal business segments: (i) brokerage services and (ii) software products and services. The brokerage services segment represents the operations of TradeStation Securities and the software products and services segment represents the operations of TradeStation Technologies.

Effective April 2004, TradeStation Securities and TradeStation Technologies amended their intercompany licensing and support agreement and, with the parent company and a presently-inactive subsidiary, entered into an expense-sharing agreement to reflect current business relationships and to comply with applicable regulatory requirements (these two agreements are collectively referred to in this report as “intercompany expense allocation agreements”). These changes had no effect on the consolidated results, but did result in an increased allocation of general and administrative expenses to the brokerage services segment, and a corresponding decrease in general and administrative expenses to the software products and services segment, of approximately $428,000 for the year ended December 31, 2004.

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For the periods indicated, the following table presents certain items in our consolidated statements of income by segment:

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Critical Accounting Policies and Estimates

Our significant accounting policies are described in Note 1 of Notes to Consolidated Financial Statements included in this report – DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates.

Net Brokerage Revenues. Net brokerage revenues is the key component of our results of operations and are comprised mainly of commission income for securities, futures and forex transactions and, to a lesser extent, monthly platform fees earned from brokerage customers using the TradeStation online trading platform, interest earned and paid from self-clearing operations and interest revenue sharing arrangements with clearing agent firms. Brokerage commission income and related clearing costs are recorded on a trade date basis as transactions occur. Platform fees are recorded on an accrual basis as monthly services are provided. Interest revenue from customer margin debit balances and customer cash balances and interest expense incurred on customer cash balances is recorded on an accrual basis as interest is earned or incurred.

Income Taxes. As of December 31, 2004, we had net deferred income tax assets of $3.8 million, which included a valuation allowance of $926,500. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109, Accounting for Income Taxes, deferred income tax assets should be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred income tax assets will not be realized. Management evaluates and determines on a periodic basis the amount of the valuation allowance required and adjusts the valuation allowance as needed. In June 2004, we reversed a significant portion of the valuation allowance that was provided on our deferred income tax assets. In the opinion of management, it was more likely than not that these benefits would be realized. This decision was triggered primarily by TradeStation Securities receiving final approval by the DTCC to begin self-clearing for equities, the rollout of TradeStation 8 (which included integrated options execution), as well as eight consecutive quarters of income from operations at the end of the 2004 second quarter. The result of this reversal, as recorded in the 2004 second quarter, was a net income tax benefit of $3.2 million recorded in the consolidated statement of income and a $3.3 million credit to additional paid-in capital (relating to the tax benefit of stock option exercises). The remaining valuation allowance of $926,500 relates to net operating loss carryforwards from a 1999 acquisition. We did not reverse the remaining $926,500 valuation allowance as the acquired net operating loss carryforwards (expiring in 2018 and 2019) are subject to annual usage limitations. The portion which was not reversed represents the last five years of the annual limitation amount due to the inability to estimate taxable income that far into the future. Management will continue to make periodic evaluations of the valuation allowance and will determine periodic adjustments, as required. See “Income Taxes” below, and Note 12 of Notes to Consolidated Financial Statements – INCOME TAXES.

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Allowance for Potential Credit Losses. We perform periodic credit evaluations and provide allowances based upon our assessment of specifically identified unsecured receivables and other factors, including the customer’s likelihood to pay and payment history. See Note 2 of Notes to Consolidated Financial Statements – SELF-CLEARING OPERATIONS, Note 4 – RECEIVABLES FROM BROKERAGE CUSTOMERS, NET, and Note 17 – COMMITMENTS AND CONTINGENCIES – General Contingencies and Guarantees.

Uninsured Loss Reserves. We decided, as of June 1, 2002, to no longer carry errors or omissions insurance that covers third-party claims made by brokerage customers or software subscribers as a result of alleged human or system errors, failures, acts or omissions. This decision was made based upon our assessment of the potential risks and benefits, including significant increases in premium rates, deductibles and coinsurance amounts, reductions in available per occurrence and aggregate coverage amounts, and the unavailability of policies that sufficiently cover the types of risks that relate to our business. Each quarter, we continue to evaluate our accruals for settlements related to claims and potential claims. Estimates of settlements for such potential claims, including related legal fees, are accrued in the consolidated financial statements. The ultimate outcome of such potential claims may be substantially different than our estimates. During 2004, we reversed $569,000 of our accruals related to a third-party claim which had been inactive for over one year (and has remained inactive for an additional year). During 2003, we reduced our accruals by $301,000 as a result of the favorable resolution or reassessment of various claims. See “Brokerage Services Segment – Operating Expenses – General and Administrative” and “Software Products and Services Segment – Operating Expenses – General and Administrative” in both “Years Ended December 31, 2004 and 2003” and “Years Ended December 31, 2003 and 2002.”

Sublease of Facilities. During the second quarter of 2002, we completed the consolidation of our Florida operations to one location. Based upon advice from our outside real estate advisors, using market factors available at the time, we estimated the potential losses relating to the sublease of facilities that we would no longer occupy. During the years ended December 31, 2003 and 2002, we increased our estimated loss accrual by $70,000 and $733,000, respectively, based on then-current market factors and actual sublease arrangements. Net payments of $192,000, $290,000 and $380,000 were applied against this accrual during 2004, 2003 and 2002, respectively, resulting in a balance of $320,000 as of December 31, 2004.

Years Ended December 31, 2004 and 2003

Overall

Net revenues were $71.8 million for the year ended December 31, 2004, as compared to $60.1 million for the year ended December 31, 2003, an increase of $11.7 million, or 19%, due to increases in net brokerage revenues of $10.9 million and subscription fees of $1.1 million, partially offset by a decrease in other revenues of $269,000.

Income from operations was $14.4 million for the year ended December 31, 2004, as compared to $10.7 million for the year ended December 31, 2003, an improvement of $3.7 million, or 34%. This improvement was due primarily to higher brokerage revenues, net of related clearing and execution costs, and increased subscription fees, partially offset by a decrease in other revenues and increases in each operating expense category.

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Other income, net consists primarily of interest income earned on our cash and cash equivalents offset by interest expense related to capital lease obligations and bank fees, as well as gains or losses on the sale of assets. Other income, net was $396,000 for the year ended December 31, 2004, as compared to $166,000 for the year ended December 31, 2003. The increase of $230,000 was due primarily to an increase in interest income of $75,000 during 2004, lower interest expense during 2004 of $64,000 (the result of fewer capital lease obligations), and a $55,000 loss on the sale of securities investments during 2003.

A net income tax provision of $118,000 was recorded during the year ended December 31, 2004 as compared to a net income tax benefit of $731,000 for the year ended December 31, 2003. In 2004, the company’s effective income tax rate of approximately 38% was mostly offset by the reversal of a significant portion of our valuation allowance on our deferred income tax assets. In 2003, the net income tax benefit was associated mainly with income tax refunds. See “Income Taxes” below.

Brokerage Services Segment

Revenues

Net Brokerage Revenues. Net brokerage revenues are comprised mainly of brokerage commission income and fees earned from brokerage customers’ securities, futures and forex transactions and, to a lesser extent, monthly platform fees earned from brokerage customers using the TradeStation electronic trading platform, interest revenue sharing arrangements with the brokerage’s clearing agent firms, and, beginning with the September 2004 commencement of self-clearing of equities trades for our active trader client base, interest revenue earned from customer margin debit balances and customer cash balances less interest expense incurred on customer cash balances. For the year ended December 31, 2004, net brokerage revenues were $61.7 million (which included brokerage commissions of $44.5 million), net of $739,000 of interest expense paid on customer cash balances, as compared to brokerage revenues of $50.9 million (which included brokerage commissions of $40.4 million) for the year ended December 31, 2003. This $10.9 million increase, or 21%, was due primarily to increased trading activity and platform fees related to brokerage customer account growth, partially offset by a decrease in our commission pricing effective November 1, 2003. The industry has been experiencing price pressure and some of our competitors have recently reduced trading commissions and fees. Although we are currently comfortable with our pricing, we continuously review and assess it, and it is possible that our pricing will be refined or adjusted at times during 2005.

Other Revenues. Other revenues are comprised primarily of fees for our training workshops that help customers take full advantage of the state-of-the-art features of the TradeStation electronic trading platform. Other revenues were $254,000 for the year ended December 31, 2004, as compared to $219,000 in the prior year, an increase of $35,000, or 16%. This increase was the result of training workshops being offered in all twelve months of 2004, as opposed to not being offered until March during the 2003 period.

Operating Expenses

Clearing and Execution Costs. Clearing and execution costs are the costs associated with executing and clearing customer trades, including commissions paid to third-party broker-dealers, exchanges and other market centers. Beginning in 2004, clearing and execution costs include new expenses related to our self-clearing operations, primarily personnel and related

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expenses, back-office systems, statement and confirmation processing, postage costs and clearing expenses paid to the DTCC. Prior to the September 2004 commencement of self-clearing operations, we incurred incremental and start-up costs of approximately $1.4 million, which were comprised primarily of personnel and related expenses and consulting and travel expenses, for which we received no offsetting cost-savings.

Clearing and execution costs were $21.3 million for the year ended December 31, 2004, as compared to $17.9 million for the year ended December 31, 2003, an increase of $3.4 million, or 19%. This increase was due primarily to increased trading activity related to brokerage customer account growth and $1.4 million of incremental and start-up costs related to the period prior to the commencement of self-clearing equities trades. Beginning September 2004, these increases were partially offset by the benefits received from self-clearing equities trades. Also, in the 2003 second quarter, we incurred approximately $400,000 of increased costs for futures clearing imposed by our former futures clearing agent that were not incurred in 2004.

Clearing and execution costs, as a percentage of net brokerage revenues were approximately 35% for the years ended December 31, 2004 and 2003. For the first nine months of 2004 (prior to the first full quarter of self-clearing equities trades), clearing and execution costs as a percentage of net brokerage revenues were 38%, as compared to 35% during 2003, due primarily to the incremental and start-up costs in 2004 related to self-clearing equities trades and brokerage commission price reductions implemented near the end of 2003. While no assurances can be given, assuming we make no decreases in pricing to our customers, we expect to see improvement in clearing and execution costs as a percentage of net brokerage revenues in 2005, as compared to 2004, given that 2005 will not include the impact of the incremental and start up costs for equities self-clearing we incurred in 2004. In 2005, clearing and execution costs may also decrease when TradeStation Securities commences full self-clearing of standardized equity option trades through use of its OCC membership.

Data Center Costs. Data center costs are primarily intercompany subscription fees, eliminated upon consolidation, and, to a lesser extent, data communications costs necessary to connect our server farms directly to electronic market places. The intercompany subscription fees are pursuant to one of the intercompany expense allocation agreements, and are paid on a per user basis to the software products and services segment for providing streaming real-time, Internet-based trading analysis software and data services to brokerage customers. See “Technology Development” below. Data center costs were $17.2 million for the year ended December 31, 2004, as compared to $15.2 million for the year ended December 31, 2003, an increase of $2.0 million, or 13%, related primarily to an increase in intercompany subscription fees paid to the software products and services segment, which resulted mainly from an increase in the number of brokerage accounts during 2004 as compared to 2003. See “Software Products and Services Segment – Revenues – Subscription Fees” and “- Operating Expenses—Data Center Costs.”

Technology Development. Technology development expenses consist primarily of personnel costs associated with product management of the brokerage products and services TradeStation Securities offers to its customers and the creation of documentation and other training and educational materials. Technology development expenses for the year ended December 31, 2004 were $1.6 million, as compared to $1.4 million for the year ended December 31, 2003, an

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increase of $169,000, or 12%, due mainly to increased personnel and related costs. Most of the technology costs required for our brokerage firm to offer and operate a highly sophisticated electronic trading platform are borne by its technology affiliate, which licenses that technology to the brokerage firm pursuant to an intercompany agreement. See “Software Products and Services Segment – Operating Expenses—Technology Development.”

Sales and Marketing. Sales and marketing expenses consist primarily of: personnel costs for sales, customer support centers, marketing and order desk, as well as brokers’ commissions; marketing programs, including advertising, brochures, direct mail programs and account opening kits; data and information tools used by sales and brokerage personnel; and Web-site maintenance and administration costs. Sales and marketing expenses were $11.3 million for the year ended December 31, 2004, as compared to $9.9 million for the year ended December 31, 2003, an increase of $1.4 million, or 15%, due primarily to increased advertising and promotional expenses of $1.8 million. Sales and marketing expenses are anticipated to continue to increase in 2005 as we ramp up our advertising and seek to grow our sales force to grow our customer account base.

General and Administrative. General and administrative expenses consist primarily of costs for administrative personnel such as executive, human resources, finance, compliance and information technology employees; professional fees; telecommunications; rent; insurance; and other facility expenses. General and administrative expenses were $5.8 million for the year ended December 31, 2004, as compared to $4.2 million for the year ended December 31, 2003, an increase of $1.6 million, or 39%. This increase is due primarily to increases in professional fees of $1.3 million, personnel and related costs of $241,000 and insurance of $218,000, partially offset by decreases in settlement costs of $299,000. Professional fees increased during 2004 as compared to 2003 due to increased legal fees related to ongoing litigation and claims, and increased accounting fees related to the requirements of Section 404 of the Sarbanes-Oxley Act of 2002. Higher insurance costs were primarily the result of increased cost of directors’ and officers’ liability insurance. Accounting fees and insurance costs were also impacted by an increased allocation under the intercompany expense allocation agreements. These increases were partially offset by the 2004 first quarter reversal of an uninsured loss provision and related legal fees of $569,000 for a third-party claim which had remained inactive for over one year, versus the 2003 reversal of uninsured loss provisions and related legal fees of $201,000 due to the favorable settlement of two claims.

Software Products and Services Segment

Revenues

Subscription Fees. Subscription fees represent monthly fees earned for providing streaming real-time, Internet-based trading analysis software tools and data services. Subscription fees also include intercompany revenue for licensing to TradeStation Securities pursuant to one of the intercompany expense allocation agreements, on a per user basis, the right to provide these software tools and data services to the brokerage customers of TradeStation Securities (“Intercompany Subscription Fees”). Intercompany Subscription Fees have no effect on the consolidated results. Subscription fees were $24.5 million for the year ended December 31, 2004, as compared to $21.3 million for the year ended December 31, 2003, an increase of $3.2 million, or 15%, due primarily to an increase in Intercompany Subscription Fees resulting from increased brokerage accounts at TradeStation Securities. Excluding Intercompany Subscription

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Fees, subscription fees were $8.1 million for the year ended December 31, 2004, as compared to $7.0 million for the year ended December 31, 2003, an increase of $1.1 million, or 16%, as a result of price increases to certain groups of subscribers during September 2003 and May 2004, partially offset by a decrease in the number of subscribers. Subscription services have not been actively marketed since December 2000.

Other Revenues. Other revenues consist primarily of royalties and commissions received from third parties whose customers use our legacy software products and, to a lesser extent, licensing fees derived from direct sales of our legacy customer software products and revenues from our annual user conference that highlights strategy testing. Other revenues were $1.7 million for the year ended December 31, 2004, as compared to $2.0 million for the year ended December 31, 2003, a decrease of $303,000, or 15%. This decrease was comprised of decreased royalties and licensing fees totaling $586,000, partially offset by $283,000 of revenue earned from our annual user conference which was not held in 2003. The expected decrease in royalties and licensing fees is the result of no longer marketing legacy customer software since May 2000 and no longer offering legacy customer software products domestically since September 2001. Other revenues are expected to continue to decrease in 2005.

Operating Expenses

Data Center Costs. Data center costs represent expenses related to the operation, maintenance and support of our data server farms. These expenses consist primarily of rent and data communications costs at our facilities where the data server farms are located, including costs necessary to connect our data server farms directly to electronic marketplaces, depreciation and maintenance of servers, and data distribution and exchange fees. Data center costs for the year ended December 31, 2004 were $5.2 million, as compared to $4.1 million for the year ended December 31, 2003, an increase of $1.0 million, or 24%. The increase is due primarily to increased rent and data communication charges at our facilities of $1.7 million, partially offset by lower data distribution and exchange fees of $658,000. The decrease in data distribution and exchange fees resulted from increased recovery of exchange fees from customer accounts and, beginning during the 2003 fourth quarter, receipt of data directly from exchanges (as opposed to a data vendor who is paid monthly fees), partially offset by incremental costs related to account growth and approximately $208,000 of credits received during 2003 from our data vendor.

Technology Development. Technology development expenses include: expenses associated with the development of new products, services and technology; enhancements to existing products, services and technology; and testing of products and services. Technology development expenses consist primarily of personnel costs, depreciation of computer and related equipment, facility expenses and telecommunications costs. TradeStation Technologies owns all intellectual property rights relating to our businesses, including, but not limited to, all order execution technology. Technology development expenses were $5.8 million for the year ended December 31, 2004 and $5.7 million for the year ended December 31, 2003, an increase of $100,000, or 2%.

Sales and Marketing. We no longer actively market software products and services, the focus of our business being online brokerage services for active and institutional traders. Sales and marketing expenses consisted primarily of personnel costs and, to a lesser extent, facility costs. Sales and marketing expenses were $531,000 for the year ended December 31, 2004, as compared to $596,000 for the year ended December 31, 2003, a decrease of $65,000, or 11%.

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Sales and marketing expenses are expected to be less in 2005 due primarily to the transfer of substantially all of the customer support team from the software products and services segment to the brokerage services segment in April 2004.

General and Administrative. General and administrative expenses consist primarily of costs for administrative personnel, such as: executive, human resources, finance and information technology employees; professional fees; telecommunications; rent; other facility expenses; amortization of intangible assets; and insurance. General and administrative expenses were $5.1 million for the year ended December 31, 2004, as compared to $4.6 million for the year ended December 31, 2003, an increase of $502,000, or 11%. This increase was due primarily to increased professional fees of $442,000 (related to increased legal fees for ongoing litigation and claims and increased accounting fees related to the requirements of Section 404 of the Sarbanes-Oxley Act of 2002), increased personnel and related costs of $467,000 and a higher provision for settlement costs of $130,000. These increases were partially offset by a favorable adjustment of $251,000 resulting from a prior years’ sales tax audit and decreased telecommunication costs of $292,000.

Years Ended December 31, 2003 and 2002

Overall

Total revenues were $60.1 million for the year ended December 31, 2003, as compared to $48.4 million for the year ended December 31, 2002, an increase of $11.7 million, or 24%, due primarily to an increase in brokerage revenues of $12.4 million, slightly offset by a decrease in other revenues (which relate primarily to our legacy software business, which is no longer an active focus).

Income from operations was $10.7 million for the year ended December 31, 2003, as compared to $1.3 million for the year ended December 31, 2002, an improvement of $9.4 million, or 700%. This improvement was due primarily to higher brokerage revenues, net of related clearing and execution costs, and decreases in all other operating expense categories. The increase in income from operations was partially offset by a $1.25 million recovery of an insurance claim in the 2002 third quarter which reduced operating expenses for that period, as well as a decrease in other revenues in 2003.

Other income, net was $165,000 for the year ended December 31, 2003, as compared to $427,000 for the year ended December 31, 2002. The decrease of $262,000 was due primarily to a 2002 gain of $287,500 recorded on the sale of legacy customer accounts, a 2003 loss of $55,000 on the sale of investments in corporate stock, and a decrease in interest income of $38,000 as a result of lower interest rates, partially offset by a decrease in interest expense of $146,000 as a result of fewer capital lease obligations.

Income tax benefit, net of expense, of $731,000 was recorded during the year ended December 31, 2003. See “Income Taxes” below.

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Brokerage Services Segment

Revenues

Net Brokerage Revenues. For the year ended December 31, 2003, net brokerage revenues were $50.9 million (which included brokerage commissions and fees of $40.4 million), as compared to brokerage revenues of $38.5 million (which included brokerage commissions and fees of $34.4 million) for the year ended December 31, 2002. This $12.4 million increase, or 32%, was due primarily to brokerage customer account growth.

Other Revenues. Other revenues were $219,000 for the year ended December 31, 2003. There were no other revenues for the year ended December 31, 2002.

Operating Expenses

Clearing and Execution Costs. Clearing and execution costs were $17.9 million for the year ended December 31, 2003, as compared to $11.3 million for the year ended December 31, 2002, an increase of $6.6 million, or 59%, due primarily to increased trading activity related to brokerage customer account growth and, to a lesser extent, an increase in futures clearing costs during the 2003 second quarter prior to our May 2003 change in futures clearing agents.

Clearing and execution costs, as a percentage of brokerage revenues, increased to 35% for the year ended December 31, 2003, as compared to 29% for the year ended December 31, 2002 due primarily to: (i) the lower gross margins that resulted from our equities per share pricing structure first offered in the second quarter of 2002; (ii) overall price reductions; and (iii) increased costs for futures clearing, during the second quarter of 2003, imposed by our former futures clearing agent.

Data Center Costs. Data center costs were $15.2 million for the year ended December 31, 2003, as compared to $10.5 million for the year ended December 31, 2002, an increase of $4.7 million, or 44%, due primarily to the increased number of brokerage accounts during 2003 as compared to 2002, partially offset by a 17% decrease in the per account Intercompany Subscription Fee charged by TradeStation Technologies to TradeStation Securities during 2003. See “Software Products and Services Segment – Revenues – Subscription Fees” and “- Operating Expenses—Data Center Costs.”

Technology Development. Technology development expenses for the year ended December 31, 2003 were $1.4 million, as compared to $644,000 for the year ended December 31, 2002, an increase of $759,000, or 118%, due mainly to increased personnel and related costs as a result of the transfer to the brokerage services segment of seven positions from the software products and services segment at the beginning of the 2002 fourth quarter. Most of the technology costs required for our brokerage firm to offer and operate a highly sophisticated electronic trading platform are borne by its technology affiliate, which licenses that technology to the brokerage firm pursuant to an intercompany agreement. See “Software Products and Services Segment – Operating Expenses—Technology Development.”

Sales and Marketing. Sales and marketing expenses were $9.9 million for the year ended December 31, 2003, as compared to $11.2 million for the year ended December 31, 2002, a decrease of $1.3 million, or 12%, due primarily to decreased advertising and promotional costs.

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General and Administrative. General and administrative expenses were $4.2 million for the year ended December 31, 2003, as compared to $4.9 million for the year ended December 31, 2002, a decrease of $686,000, or 14%. This decrease is due primarily to a decrease in facility costs of $522,000 (related primarily to the estimated loss on the sublease of facilities recorded during 2002), and the 2003 reversal of certain uninsured loss provisions including related legal fees in the amount of $201,000 due to the favorable settlement of certain claims, partially offset by increased communications costs of $148,000. See “Critical Accounting Policies and Estimates – Sublease of Facilities” and “– Uninsured Loss Reserves.”

Software Products and Services Segment

Revenues

Subscription Fees. Subscription fees were $21.3 million for the year ended December 31, 2003, as compared to $16.4 million for the year ended December 31, 2002, an increase of $4.9 million, or 30%, due primarily to a $4.5 million increase in Intercompany Subscription Fees which resulted from increased brokerage accounts at TradeStation Securities, partially offset by a decrease in the per account Intercompany Subscription Fee charged by TradeStation Technologies to TradeStation Securities during 2003. Excluding Intercompany Subscription Fees, subscription fees were $7.0 million for the year ended December 31, 2003, as compared to $6.6 million for the year ended December 31, 2002, an increase of $395,000, or 6%, as a result of a change to higher-priced subscription offerings during 2003, partially offset by a decrease in the number of subscribers. Subscription services have not been actively marketed since December 2000.

Other Revenues. Other revenues were $2.0 million for the year ended December 31, 2003, as compared to $3.3 million for the year ended December 31, 2002, a decrease of $1.2 million, or 37%. This expected decrease is the result of no longer marketing legacy customer software since May 2000 and no longer offering legacy customer software products domestically since September 2001.

Operating Expenses

Data Center Costs. Data center costs for the year ended December 31, 2003 were $4.1 million, as compared to $4.8 million for the year ended December 31, 2002, a decrease of $648,000, or 14%. The decrease is due primarily to lower data distribution and exchange fees of $448,000, and lower server costs of $240,000, partially offset by increased rent and data communication charges at our data center facilities of $40,000. The decrease in data distribution and exchange fees resulted from approximately $208,000 of credits received from data providers, increased recovery of exchange fees from customer accounts and, beginning during the 2003 fourth quarter, receipt of data directly from exchanges, partially offset by incremental costs related to account growth.

Technology Development. Technology development expenses were $5.7 million for the year ended December 31, 2003, as compared to $8.2 million for the year ended December 31, 2002, a decrease of approximately $2.5 million, or 30%, due primarily to decreased personnel and related costs of $2.0 million (due to fewer employees in 2003 as compared to 2002, including ten terminations and the transfer of seven positions to the brokerage segment at the beginning of the 2002 fourth quarter) and, to a lesser extent, decreased facility costs of $253,000 related to the June 2002 consolidation of our facilities and decreased communications costs of $171,000.

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Sales and Marketing. We no longer actively market software products and services, the focus of our business being to continue to build an online brokerage firm for active and institutional traders. During 2003, sales and marketing expenses consisted primarily of personnel costs for customer support centers and facility costs. In prior years, sales and marketing expenses consisted primarily of marketing programs, including advertising, brochures, and direct mail programs; sales commissions; personnel costs for marketing and customer support centers; Web site maintenance and administration costs; and inventory and handling costs. Sales and marketing expenses were $596,000 for the year ended December 31, 2003, as compared to $1.3 million for the year ended December 31, 2002, a decrease of $698,000, or 54%, due primarily to a decrease in personnel and related costs of $460,000, a favorable resolution of an event cancellation dispute during 2003 which resulted in a reduction of expenses of $112,000, and a decrease in technical support costs of $133,000.

General and Administrative. General and administrative expenses were $4.6 million for the year ended December 31, 2003, as compared to $5.2 million for the year ended December 31, 2002, a decrease of $584,000, or 11%. This decrease was due primarily to decreased amortization of intangible assets of $689,000 (fully amortized in October 2002), decreased personnel and related costs of $123,000 and the 2003 reversal of uninsured loss provisions in the amount of $100,000 due to the reassessment of certain potential claims, partially offset by increased facility costs of $192,000 and increased consulting and professional fees of $122,000.

(Recovery of) Provision for Insurance Claim. In June 2001, we made a claim of $2.7 million with our insurance carrier relating to a trading error made with respect to a customer’s account. As of the 2001 year end, the insurance company had formally denied this claim and, accordingly, the receivable that had been recorded in our consolidated balance sheet was fully reserved. On July 25, 2002, we entered into an agreement with the insurance company to settle this claim for $1.25 million, payment of which was received in August 2002. Accordingly, during the third quarter of 2002, we recorded a recovery of $1.25 million.

Income Taxes

During the year ended December 31, 2004, we recorded an income tax provision, net of benefits, of $118,000. In 2004, the company’s effective income tax rate of approximately 38% was primarily offset by the reversal of a significant portion of our valuation allowance on our deferred income tax assets. In June 2004, we reversed a significant portion of the valuation allowance that was provided on our deferred income tax assets. In the opinion of management, it was more likely than not that these benefits would be realized. In accordance with SFAS No. 109, Accounting for Income Taxes, deferred income tax assets should be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred income tax assets will not be realized. Management evaluates and determines, on a periodic basis, the amount of the valuation allowance required and adjusts the valuation allowance, as needed. The decision to reverse a significant portion of the valuation allowance was triggered primarily by TradeStation Securities receiving final approval by the DTCC to begin self-clearing for equities, the rollout of TradeStation 8 (which includes integrated options execution), as well as eight consecutive quarters of income from operations. In the 2004 second quarter, the result of this reversal was a net tax benefit of $3.2 million recorded in the consolidated statement of income and a $3.3 million credit to additional paid-in capital (relating to the tax benefit of stock option exercises). As of December 31, 2004, we had net deferred income tax assets of $3.8 million, which included a valuation allowance of $926,500, pertaining to net operating loss carryforwards from a 1999

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acquisition. We did not reverse the remaining valuation allowance as the acquired net operating loss carryforwards (expiring in 2018 and 2019) are subject to annual usage limitations. The portion which was not reversed represents the last five years of the annual limitation amount due to the inability to estimate taxable income that far into the future. Management will continue to make periodic evaluations of the valuation allowance and will determine periodic adjustments, as required.

As of December 31, 2004, for federal income tax purposes, we had available total net operating loss carryforwards and income tax credit carryforwards of approximately $6.1 million and $983,000, respectively (expiring between 2018 and 2024). These amounts include $3.6 million of net operating loss carryforwards and $124,000 of income tax credits (expiring between 2010 and 2019) that relate to a 1999 acquisition, and are subject to annual usage limitations of approximately $545,000. These limitations are cumulative to the extent they are not utilized in any year. Additionally, the company has available approximately $242,000 of corporate income tax credits for current year minimum federal income tax liability, which can be carried forward indefinitely. For Florida state income tax purposes, the company has available net operating loss carryforwards estimated at $14.4 million (expiring in 2020 through 2023).

During the year ended December 31, 2003, we recorded a net income tax benefit of $731,000 consisting of refunds related to prior year federal income tax returns (see below), and state income tax refunds received during 2003 for the overpayment of a prior year’s income tax, partially offset by an increase to the valuation allowance established for the estimated amount due under the 2003 alternative minimum tax calculation. Other than the increase to the valuation allowance for the estimated amount due under the 2003 alternative minimum tax calculation, the income tax expense associated with net operating income generated during the year ended December 31, 2003 was totally offset by a reduction to the previously established valuation allowance, including the net operating loss carryforwards.

In February 2003, in connection with an Internal Revenue Service (“IRS”) audit of a prior year’s federal income tax return, we learned that we were entitled to a $72,000 refund related to research and development tax credits. We recorded that benefit in the 2003 first quarter. Also in conjunction with the IRS audit, in late April 2003 we were advised that we were due a refund relating to our 1997 federal income taxes paid. Accordingly, during the 2003 second quarter, we recorded a benefit of approximately $802,000. The full amount of the income tax receivable and related interest thereon was received during October 2003.

During the year ended December 31, 2002, the income tax expense associated with net operating income generated during the year was offset by a reduction to the previously established valuation allowance, and taxes were only provided for certain state and local income taxes where our net operating loss carryforwards could not be utilized, resulting in a tax provision of $4,000.

See Note 12 of Notes to Consolidated Financial Statements – INCOME TAXES.

Variability of Results

The operating results for any quarter are not necessarily indicative of results for any future period or for the full year. Our quarterly revenues and operating results have varied in the past,

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and are likely to vary in the future. Such fluctuations are likely to result in volatility in the price of our common stock. See Issues, Uncertainties and Risk Factors below and Note 19 of Notes to Consolidated Financial Statements – UNAUDITED QUARTERLY FINANCIAL INFORMATION.

Liquidity and Capital Resources

As of December 31, 2004, we had cash and cash equivalents of approximately $32.1 million, of which $1.9 million was restricted, supporting a facility lease. See Note 17 of Notes to Consolidated Financial Statements – COMMITMENTS AND CONTINGENCIES – Restricted Cash.

As of December 31, 2004, TradeStation Securities had: $347.1 million of cash segregated in compliance with federal regulations, in special reserve bank accounts for the exclusive benefit of customers under Rule 15c3-3 of the Securities Exchange Act of 1934 and other regulations; net receivables from brokerage customers of $57.0 million; and receivables from brokers, dealers, clearing organizations and clearing agents of $19.4 million. Client margin loans are demand loan obligations secured in part by cash and/or readily marketable securities. Receivables from and payables to brokers, dealers, clearing organizations and clearing agents primarily represent current open transactions, which usually settle, or can be closed out, within a few business days.

Liquidity needs relating to client trading and margin borrowing activities are met primarily through cash balances in brokerage client accounts, which were $420.7 million at December 31, 2004. Management believes that brokerage cash balances and operating earnings will continue to be the primary source of liquidity for TradeStation Securities in the future.

TradeStation Securities is subject to the net capital requirements of the SEC’s Uniform Net Capital Rule (Rule 15c3-1) and the CFTC’s financial requirement (Regulation 1.17). In September 2004, upon commencement of self-clearing of equities trades, TradeStation Securities changed its calculation of net capital requirements to the “alternative method,” which requires the maintenance of minimum net capital, as defined by the rules, equal to the greater of (i) $250,000 and (ii) 2.0% of aggregate customer debit balances. Customer debit items are a function of customer margin receivables and may fluctuate significantly, resulting in a significant fluctuation in our net capital requirements. At December 31, 2004, TradeStation Securities had net capital of approximately $23.6 million (27.0% of aggregate debit items), which was approximately $21.8 million in excess of its required net capital of approximately $1.7 million.

In addition to net capital requirements, as a self-clearing broker-dealer, TradeStation Securities is subject to DTCC, OCC, clearing agent and other cash deposit requirements which are and may continue to be large in relation to TradeStation Group’s total liquid assets, and which may fluctuate significantly from time to time based upon the nature and size of TradeStation Securities’ active trader clients’ securities trading activity. As of December 31, 2004, we had interest-bearing security deposits totaling $14.5 million with clearing organizations and clearing agents for the self-clearing of stock trades and the omnibus clearing of standardized equity option trades. Now that TradeStation Securities’ membership application with the OCC has been approved (approval was given March 7, 2005), additional fluctuations and adjustments in cash deposits are expected.

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A summary of our long-term debt obligations, capital lease obligations (net of interest and sales tax), operating lease obligations (net of subleases), and minimum purchase obligations (related to back-office systems, telecommunications services and advertising) as of December 31, 2004 is as follows:

In addition to the purchase obligations set forth in the table above, we currently anticipate, in connection with the expected growth of our brokerage business, capital expenditures of up to $2.0 million in 2005 (primarily for the purchase of computer hardware and software to support the growth of our data server farms and other operations). These expenditures are expected to be funded through operating cash flows, capital leases, or a combination of the two.

We anticipate that our available cash resources and cash flows from operations will be sufficient to meet our presently anticipated working capital and capital expenditure requirements through at least the next twelve months.

Cash provided by operating activities totaled approximately $515,000, $13.3 million and $4.8 million during the years ended December 31, 2004, 2003, and 2002, respectively. Net cash provided by operating activities was due primarily to net income, as adjusted for non-cash items, including the reversal of the valuation allowance associated with deferred income tax assets, partially offset by net cash outflows associated with the commencement of self-clearing operations during September 2004 including $14.5 million of deposits paid to clearing organizations. Net cash provided by operating activities during 2003 was due primarily to net income, as adjusted for non-cash items, partially offset by an increase in accrued expenses. Net cash provided by operating activities during 2002 was due primarily to net income (including $1.25 million received in an insurance settlement), as adjusted for non-cash items, and an increase in accounts payable and accrued expenses, partially offset by an increase in receivables from clearing organizations.

Investing activities provided cash of $450,000 during the year ended December 31, 2004 due to $2.0 million of proceeds from the maturity of marketable securities and a decrease in restricted cash of $239,000, partially offset by capital expenditures of $1.4 million (mostly computer hardware and software for our data server farms and our back-office systems to support the growth of our business) and the acquisition of exchange membership seats of $415,000. Investing activities used cash of $2.4 million during the year ended December 31, 2003 mainly for the purchase of marketable securities of $2.0 million and capital expenditures of $1.3 million, (mostly computer hardware and software to support the growth of our business operations), partially offset by a decrease in restricted cash of $927,000. During the year ended December 31, 2002, net cash provided by investing activities of $19,000 was due primarily from cash

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proceeds of $1.0 million from the sale of legacy brokerage customers, a decrease in restricted cash of $540,000, proceeds from maturity of marketable securities of $315,000, partially offset by capital expenditures of $1.7 million and the acquisition of data rights for $100,000.

Financing activities provided cash of $900,000 and $4.5 million during the years ended December 31, 2004 and 2003, respectively, and used cash of $8.2 million during 2002. Proceeds from the issuance of common stock related to the exercise of stock options from our incentive stock plans, and purchases under our employee stock purchase plan, provided cash of $1.1 million, $4.8 million and $43,000 during 2004, 2003 and 2002, respectively.

In connection with the initial public offering of the predecessor to TradeStation Securities, warrants to purchase up to 225,000 shares of that predecessor company’s common stock, at an exercise price of $11.55, were granted to the underwriters, with an expiration date of June 9, 2004. We assumed such warrants in connection with the merger between TradeStation Technologies and TradeStation Securities, and, based on the 1.7172 to 1 merger conversion ratio, the underwriters were granted rights to purchase up to 386,369 shares of the company’s common stock at an exercise price of $6.73. In July 2003, we filed a registration statement with the Securities and Exchange Commission to register the warrants and the 386,369 shares of common stock issuable upon the exercise of such warrants, which was declared effective by the Securities and Exchange Commission on August 13, 2003. During the second half of 2003, we issued 196,807 shares of common stock associated with the exercise of warrants in exchange for net cash proceeds of $914,000 and the delivery and cancellation of 123,027 warrants. During 2004, we issued 1,851 shares of common stock associated with the exercise of warrants in exchange for the delivery and cancellation of 4,108 warrants. All unexercised warrants expired in June 2004.

During 2002, net cash used in financing activities was primarily $6.9 million of cash paid for the purchase and retirement of 5 million shares of our common stock. In July 2002, we announced a stock repurchase program authorizing, at the discretion of management, the use of available cash to purchase from time to time up to 4 million shares of our common stock in the open market or through privately-negotiated transactions. Through October 2002, we had purchased and retired all 4 million shares at prices ranging from $1.35 to $1.40 per share, for a total purchase price of $5.5 million. This included two private transactions with a former principal shareholder of onlinetradinginc.com corp. for the purchase of 1.5 million shares at a price of $1.35 per share and 2.4 million shares at a price of $1.40 per share. In November 2002, we purchased and retired an additional one million shares at a price of $1.35 per share in a private transaction with another former principal shareholder of onlinetradinginc.com corp., bringing the total shares of common stock purchased and retired for the year to 5 million, for a total purchase price of $6.9 million. During the third quarter of 2003, those former principal shareholders of onlinetradinginc.com corp. filed lawsuits seeking rescission of the share purchases and/or compensatory damages, plus interest, costs and attorneys’ fees. We believe all of the allegations are baseless. See Note 17 of Notes to Consolidated Financial Statements - COMMITMENTS AND CONTINGENCIES - Litigation and Claims for further discussion.

Repayments of capital lease obligations were $186,000, $1.2 million and $1.4 million during 2004, 2003 and 2002, respectively.

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Off-Balance-Sheet Arrangements

In the ordinary course of business, there are certain contingencies which are not reflected in the consolidated financial statements. These activities may expose the company to off-balance-sheet credit risk in the event the customers are unable to fulfill their contractual obligations.

Nearly all TradeStation Securities customer accounts are margin accounts. In margin transactions, TradeStation Securities may be obligated for credit extended to its customers by its clearing agents that are collateralized by cash and securities in the customers’ accounts with those clearing agents. In connection with securities activities, TradeStation Securities also executes customer transactions involving the sale of securities not yet purchased (“short sales”), all of which are transacted on a margin basis subject to federal, self-regulatory organization and individual exchange regulations and TradeStation Securities’ and its clearing agents’ internal policies. Additionally, TradeStation Securities may be obligated for credit extended to its customers by its clearing agents for futures transactions that are collateralized by cash and futures positions in the customers’ accounts with those clearing agents. In all cases, such transactions may expose TradeStation Securities to significant off-balance-sheet credit risk in the event customer collateral is not sufficient to fully cover losses that customers may incur. In the event customers fail to satisfy their obligations, TradeStation Securities may be required to purchase or sell financial instruments at prevailing market prices to fulfill the customers’ obligations.

TradeStation Securities seeks to control the risks associated with its customers’ activities by requiring customers to maintain collateral in their margin accounts in compliance with various regulatory requirements, internal requirements, and the requirements of clearing agents. TradeStation Securities and its clearing agents monitor required margin levels on an intra-day basis and, pursuant to such guidelines, require the customers to deposit additional collateral or to reduce positions when necessary.

TradeStation Securities provides guarantees to its clearing organization and exchanges under their standard membership agreements, which require members to guarantee the performance of other members. Under the agreements, if another member becomes unable to satisfy its obligations to the clearing organization and exchanges, other members would be required to meet shortfalls. TradeStation Securities’ liability under these arrangements is not quantifiable and may exceed the cash and securities it has posted as collateral. However, the possibility of the company being required to make payments under these arrangements is remote. Accordingly, no liability has been recorded for these potential events.

Recently Issued Accounting Standards

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS 123(R)”), which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. SFAS 123(R) must be adopted no later than July 1, 2005. Early adoption will be permitted in periods in which financial statements have not yet been

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issued. We expect to adopt SFAS 123(R) on July 1, 2005, but we have not yet determined if we will use the modified prospective method or one of the modified-retrospective methods. As permitted by SFAS 123, the company currently accounts for share-based payments to employees using the intrinsic value method in accordance with the recognition and measurement principles of APB Opinion No. 25, and, as such, generally recognizes no compensation cost for employee stock options, as options granted under the company’s plans have an exercise price equal to the fair value of the underlying common stock on the date of grant. Accordingly, the adoption of SFAS 123(R)’s fair value method may have a significant impact on our result of operations, although it will have no impact on our overall financial position. The impact of adoption of SFAS 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted SFAS 123(R) in prior periods, the impact of that standard would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net income and earnings per share in Note 1 of Notes to Consolidated Financial Statements – DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Stock-Based Compensation. SFAS 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While the company cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in 2004 for such excess tax deductions was $3.8 million. In 2003 and 2002, we had a full valuation allowance on our deferred income tax assets and, therefore, no amount was recognized for such excess tax deductions, if any.

Issues, Uncertainties and Risk Factors

The Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations, and the “BUSINESS” section of this report, should be read and evaluated together with the issues, uncertainties and risk factors relating to our business described below. While we have been and continue to be confident in our business and business prospects, we believe it is very important that anyone who reads this report consider these issues, uncertainties and risk factors, which include business risks relevant both to our industry and to us in particular. These issues, uncertainties and risk factors are not intended to be exclusive. Issues, uncertainties and risk factors are also included in other sections of this report when specifically relevant to a statement we have made about an aspect of our business, or our financial condition or results of operations.

This report also contains statements that are forward-looking within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. When used in this report, the words “anticipate(s),” “anticipated,” “anticipation,” “assume(s),” “assumption(s),” “become(s),” “belief(s),” “believe(s),” “believed,” “could,” “designed,” “estimate,” “estimates,” “estimated,” “expect(s),” “expected,” “expectation(s),” “going forward,” “future,” “hopeful,” “hope(s),” “intend(s),” “intended,” “look forward,” “may,” “opportunity,” “opportunities,” “outlook(s),” “pending,” “plan(s),” “planned,” “potential,” “scheduled,” “shall,” “should,” “think(s),” “to be,” “upcoming,” “well-positioned,” “will,” “would,” and similar expressions, if and to the extent used, are intended to identify the forward-looking statements. All forward-looking statements

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are based on current expectations and beliefs concerning future events that are subject to risks and uncertainties, including the risks and uncertainties described below and elsewhere in this report. Actual results may differ materially from the results suggested in this report. Factors that may cause or contribute to such differences, and our business risks and uncertainties generally, include, but are not limited to, the items described below, as well as those described in other sections of this report, our other public filings and our press releases.

There Are Several Factors That May Cause Fluctuations In Our Quarterly Operating Results, Which Could Result In Significant Volatility In Our Stock Price

Quarterly revenues and operating results of TradeStation Group and its predecessor companies have fluctuated significantly in the past, and our quarterly revenues and operating results are likely to fluctuate in the future. Causes of such significant fluctuations may include, but are not limited to:

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Conditions In The Securities And Financial Markets May Affect Our Rates Of Customer Acquisition, Retention And Trading Activity

Our products and services are, and will continue to be, designed for customers who trade actively in the securities and financial markets. To the extent that interest in active trading decreases due to low trading volumes, lack of volatility, or significant downward movement in the securities or financial markets, or future tax law changes, recessions, depressions, wars, terrorism (including “cyberterrorism”), or otherwise, our business, financial condition, results of operations and prospects could be materially, adversely affected. Unfavorable market conditions have, historically, seemed to severely negatively impact the share price of publicly-held online brokerage firms, and also usually result in more losses for our customers, which could result in increases in quantity and size of errors or omissions or other claims that may be made against us by customers. We do not currently carry any errors or omissions insurance that might cover, in part, some of those potential claims. See “The Nature Of Our Business Results In Potential Liability To Customers” below.

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We May Not Benefit As Much As We Think We Will From Self-Clearing Equity Trades For Active Trader Accounts

Self-clearing operations for our active trader equities accounts began in September 2004. Prior to the September conversion of clearing services, all of our customers’ equities trades were cleared through Bear Stearns, as our clearing agent, which also provided to our active trader clients its short sale borrowing inventory. Now that we have commenced self-clearing, we do so with no prior experience, and the cost savings and efficiencies of self-clearing may be less favorable than we expect as a result of unanticipated increased fixed, infrastructure or incremental costs, mistakes or other factors. Also, such anticipated savings may be more than offset by account losses or reduced trading activity if we experience difficulties in providing to our clients sufficient short sale borrowing inventory or if any self-clearing mistakes or failures occur which undermine our customers’ or prospects’ confidence in our ability to conduct reliable self-clearing operations. Also, our self-clearing back-office operations rely on the Phase3 self-clearing software licensed to us by SunGard Financial Systems, and our business would likely suffer substantial harm if that software fails, fails to be adequately supported by SunGard, or otherwise causes unintended results. Further, errors made by us related to the confirmation, receipt, settlement and delivery functions involved in securities transactions, the custody and control of client securities and other assets, or otherwise relating to the handling of our clients’ securities and funds, could lead to civil penalties and increased deposit and other requirements by governmental and self-regulatory organizations, as well as losses and liability in lawsuits relating to client accounts affected by such errors.

We Are Exposed to Credit Risk

We make margin loans to clients collateralized by client securities, and borrow securities to cover trades. In fact, nearly all of our clients’ accounts are margin, as opposed to cash, brokerage accounts. A portion of our net revenues is derived from interest on margin loans. To the extent that these margin loans exceed client cash balances maintained with us, we must obtain financing from third parties. We may not be able to obtain this financing on favorable terms or in sufficient amounts. By permitting clients to purchase securities on margin, we are subject to risks inherent in extending credit, especially during periods of rapidly declining markets in which the value of the collateral substantially decreases in proportion to the amount of a client’s indebtedness. As of February 28, 2005, we are carrying approximately $207,000 of an unsecured account debit (plus accrued interest thereon) that resulted from large losses in one client’s account that occurred in September 2004 as a result of a sudden, large adverse price movement to a concentrated securities position being maintained by that client. While we have implemented additional risk-management procedures designed to reduce this risk, there can be no assurance that we will not experience periodic or frequent unsecured account debits that materially and adversely affect our results of operations. In addition, in accordance with regulatory guidelines, we collateralize borrowings of securities by depositing cash or securities with lenders. Sharp changes in market values of substantial amounts of securities and the failure by parties to the borrowing transactions to honor their commitments could have a material, adverse effect on our revenues and profitability.

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Our Industry Is Intensely Competitive, Which Makes It Difficult To Attract And Retain Customers

The markets for online brokerage services, trading software tools, and real-time market data services are intensely competitive and rapidly evolving, and there has been substantial consolidation of those three products and services in the industry, as well as consolidation of the types of financial instruments (equities, equities options, futures, forex) offered by firms. There has also been consolidation of online brokerage firms generally. We believe that competition from large online and other large brokerage firms and smaller brokerage firms focused on active traders, as well as consolidation, will substantially increase and intensify in the future. Competition may be further intensified by the size of the active trader market, which is generally thought to be comprised of less than 10% of all online brokerage accounts. We believe our ability to compete will depend upon many factors both within and outside our control. Factors outside of our control include: price pressure (both on transactional commissions and monthly platform fees); the timing and market acceptance of new products and services and enhancements developed by our competitors (including strategy back-testing and automation capabilities); market conditions, such as recession; the size of the active trader market today and in the future; the extent to which institutional traders are willing to use direct-access brokerage services from firms that have traditionally served mostly retail customers; data availability and cost; and third-party clearing costs. Factors over which we have more control, but which are subject to substantial risks and uncertainties with respect to our ability to effectively compete, include: timing and market acceptance of new products and services and enhancements we develop; our ability to design, improve and support materially error-free Internet-based systems; ease-of-use of our products and services; reliability of our products and services; pricing decisions; the ability and resources to provide sufficient short sale inventory; self-clearing costs; and sales and other marketing decisions and efforts.

Systems Failures May Result In Our Inability To Deliver Accurately, On Time, Or At All, Important And Time-Sensitive Services To Our Customers

The online electronic trading platform we provide to our customers is based upon the integration of our sophisticated front-end software technology with our equally-sophisticated, Internet-based server farm technology. Our server farm technology is the foundation upon which online trading customers receive real-time market data and place buy and sell orders. However, in order for this technology to provide a live, real-time trading platform, it requires integration with real-time market data, which are currently provided directly by the exchanges or by systems of independent third-party market data vendors (who obtain the data directly from the exchanges), the electronic order book systems of electronic communication networks (“ECNs”) and electronic systems offered by the exchanges, the clearing and back-office systems we license from SunGard for self-clearing and of the clearing agents we use for trades that we do not self-clear, and the forex deal order placement, settlement and back-office systems of or licensed to the forex dealer firm which is responsible for all of our customer’s forex trades. Accordingly, our ability to offer a platform that enables the development, testing and automation of trading strategies and the placement, execution, clearing and settlement of buy and sell orders depends heavily on the effectiveness, integrity, reliability and consistent performance of all of these systems and technologies. In particular, the stress that is placed on these systems during peak trading times could cause one or more of these systems to operate too slowly or fail. We have experienced several delays and outages since we launched our online trading platform, many of which related to data vendor, clearing agent, exchange and ECN outages or issues which are beyond our control. Also, a hardware or software failure (a hardware failure caused a 30-minute

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post-market-open outage in October 2004), software design limitations or errors that exist in our and others’ technologies, power or telecommunications interruption or natural disaster could cause a systems failure or other potentially damaging results.

When systems in the trading process slow down significantly or fail, even for a short time, our brokerage customers could suffer delays in trading, or unintended results or other problems, potentially causing losses and possibly subjecting us to claims for such losses. Such failures or delays, depending upon how often they occur and how serious they are, could also result in our customers and customer prospects losing or failing to gain confidence in our trading platform. Additionally, as a general matter not applicable only to our company, the integrity of these types of systems is increasingly being attacked by persons sometimes referred to as “hackers” who intentionally introduce viruses or other defects to cause damage, inaccuracies or complete failure. Also, “cyberterrorism,” should it occur, may significantly affect people’s willingness to use Internet-based services, particularly ones that involve their personal or company’s assets.

During a system outage or failure, our brokerage may be able to take orders by telephone; however, only associates with appropriate licenses, knowledge and experience can accept telephone orders, and an adequate number of associates likely would not be available to take customer calls in the event of a system outage or failure. System delays, errors, outages and failures, depending upon how serious and how often they occur, could have a material adverse effect on our business, financial condition, results of operations and prospects. See “The Nature Of Our Business Results In Potential Liability To Customers” below.

We May Need Cash In The Foreseeable Future

While we anticipate having sufficient cash to meet our needs over the next 12 months, our future liquidity and capital requirements will depend upon numerous factors, including: the rate of customer acceptance of our products and services, including the number of new brokerage accounts acquired and the number and volume of trades made by our brokerage customers; the effect of price reductions; price competition that may result in our continuing to charge lower commissions and fees to customers; significant, increased infrastructure and operating costs as our business grows, including unanticipated costs for self-clearing and/or omnibus clearing operations (such as large cash or security deposits, which are $17.4 million as of February 28, 2005, and which are expected to increase as our business grows); increased net capital or excess net capital requirements and unanticipated reserve and settlement requirements; unanticipated costs relating to our new forex and options execution services; costs of technology development and sales, marketing, compliance, technical and administrative operations relating to increased and intensified pursuit of institutional customers; substantial legal costs and/or unexpected unfavorable outcomes in lawsuits and arbitrations currently pending against us; and competing technological and market developments. Funds, if and when needed, may be raised through debt financing and/or the issuance of equity securities, there being no assurance that any such type of financing on terms satisfactory to us will be available or otherwise occur. Any equity financing or debt financing which requires issuance of equity securities or warrants to the lender would reduce the percentage ownership of the shareholders of the company. Shareholders also may, if issuance of equities occurs, experience additional dilution in net book value per share, or the issued equities may have rights, preferences or privileges senior to those of existing shareholders.

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The Nature Of Our Business Results In Potential Liability To Customers

Many aspects of the securities, futures and forex brokerage business, including online trading services, involve substantial risks of liability. In recent years there has been an increasing incidence of litigation involving the securities and futures brokerage industry, including both class action and individual suits and arbitrations that generally seek substantial damages, including in some cases punitive damages. Our proprietary order routing technology, in addition to offering charting, trade analysis and trade execution services of various kinds, is designed to automatically locate, with immediacy, the best available price in the appropriate market in completing execution of a trade triggered by programmed market entry and exit rules. There are risks that the electronic communications and other systems upon which these products and services rely, and will continue to rely, or our products and services themselves, as a result of flaws or other imperfections or limitations in their designs or performance, may operate too slowly, fail, cause confusion or uncertainty to the user, or operate or produce results not understood or intended by the user. An investor or trader using either the full electronic trading platform or our subscription service might claim that investment or trading losses or lost profits resulted from use of a flawed version of one of our trading software tools or systems, or inaccurate assumptions made by the trading software tools regarding data, or inaccurate data. Major failures of this kind may affect all customers who are online simultaneously. Any such litigation could have a material adverse effect on our business, financial condition, results of operations and prospects. We do not currently carry any errors or omissions insurance that might cover, in part, some of the above-described risks. While our contracts with customers are, we believe, clear that customers who do business with us must knowingly assume all of the risks described above, there can be no assurance that a judge, arbitrator or regulator would enforce or honor such contractual provisions. See “Conditions In The Securities And Financial Markets May Affect Our Rates Of Customer Acquisition, Retention And Trading Activity,” and “Systems Failures May Result In Our Inability To Deliver Accurately, On Time, Or At All, Important And Time-Sensitive Services To Our Customers” above.

Dependence Upon Outside Data Sources And Clearing Relationships Creates Risks Outside Of Our Control Which May Affect Our Ability To Provide, And Our Cost To Provide, Market Data And Clearing And Account Services

Our business is currently dependent upon our ability to maintain contracts with private market and news data vendors and clearing and dealer firms in order to provide certain market data and news, and clearing and account services, respectively, to our customers. We currently obtain New York Stock Exchange (NYSE), American Stock Exchange (AMEX), Nasdaq, Options Price Reporting Authority (OPRA), Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBOT) and OneChicago real-time market data directly from those exchanges, but obtain other market data (such as forex data) and news pursuant to non-exclusive licenses from private data vendors who in turn obtain the data from exchanges or other sources. Clearing and back-office account services for our brokerage customers are obtained from established clearing agents and, with respect to our self-clearing operations, our software system licensing agreement with SunGard. For our forex services, we rely on a third-party forex dealer firm for all trade activity account services. The data and news contracts typically provide for royalties based on usage or minimums, the clearing contracts provide for transactional clearing fees and charges, and the contract with the forex dealer provides for sharing a fixed amount of the spread made by the forex dealer in each deal. There can be no assurance that we will be able to renew or maintain contracts or acceptable clearing cost or vendor fee rates. In fact, in 2003 we needed

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to quickly change our futures clearing agent in response to a substantial increase in our clearing costs imposed by our former futures clearing agent. Changes (or, in some cases, failure or inability to make changes) in our relationships with one or more of these third parties, or involuntary termination of one or more of those relationships, could have a material adverse effect on our business, financial condition, results of operations and prospects.

We Are Subject To Intellectual Property Litigation

There has been substantial litigation in the software industry involving intellectual property rights. Although we do not believe that we are or will be infringing upon the intellectual property rights of others, there was recently an infringement claim asserted against us and eight other online brokerage firms by a company named Datamize, Inc., which could have had a material adverse effect on our business, financial condition, results of operations and prospects if it was successful (we settled the suit in December 2004 for an amount immaterial to our financial statements). Such a case, as well as any other infringement case that may be brought against us, could result in our being unable to use intellectual property which is integral to one or more of our products or services.

We May Not Be Able To Adequately Protect Or Preserve Our Rights In Intellectual Property

Our success is and will continue to be heavily dependent on proprietary technology, including existing trading software, Internet, Web-site and order-execution technology, and those types of technology currently in development. We view our technology as proprietary, and rely, and will be relying, on a combination of copyright, trade secret and trademark laws, nondisclosure agreements and other contractual provisions and technical measures to protect our proprietary rights. We also have a pending patent application covering the TradeStation electronic platform, but we do not yet know if the patent will be issued. Policing unauthorized use of our products and services is difficult, however, and we may be unable to prevent, or unsuccessful in attempts to prevent, theft, copying or other unauthorized use or exploitation of our product and service technologies. There can be no assurance that the steps taken by us to protect (or defend) our proprietary rights will be adequate or that our competitors will not independently develop technologies that are substantially equivalent or superior to our technologies or products and services.

Operation In A Highly-Regulated Industry And Compliance Failures May Result In Severe Penalties And Other Harmful Governmental Actions Against Us

The securities and commodity futures industries are subject to extensive regulation covering all aspects of those businesses. Regulation of forex dealer and brokerage services is increasing as well. The various governmental authorities and industry self-regulatory organizations that supervise and regulate (and may soon supervise and regulate) our brokerage firm have broad enforcement powers to censure, fine, suspend, enjoin, expel or issue cease-and-desist orders to our brokerage firm or any of its officers or employees who violate applicable laws or regulations. Additionally, rules relating specifically to active traders have been enacted and more may be enacted which severely limit the operations and potential success of our business. For example, in January 2005 new “short sale” rules promulgated by the SEC became effective that may materially, adversely affect our ability to provide quality short sale brokerage services to our equities brokerage customers. Our ability to comply with all applicable laws and rules is largely dependent on our brokerage’s maintenance of compliance and reporting systems, as well as its ability to attract and retain qualified compliance and other personnel and enter into suitable

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contractual relationships with appropriate vendors, lenders and counterparties. Our brokerage could be subject to disciplinary or other regulatory or legal actions in the future due to noncompliance.

The Loss Of Key Employees Could Decrease The Quality Of Our Management And Operations

Our success depends to a very significant extent on the continued availability and performance of a number of senior management and product development personnel. The loss of one or more of these key employees could have a material adverse effect on our company.

There Are Risks Relating To Our Ability To Maintain Customer Privacy And Security And That Increased Government Regulation Of Internet Business May Occur

Customers may refuse to transact business over the Internet, particularly business, such as ours, that involves the handling of significant amounts of customers’ funds, due to privacy or security concerns. This risk will grow if, as and to the extent “cyberterrorism” occurs or is perceived to be a viable, prominent threat or likelihood to occur (or recur on a regular basis). We do incorporate security measures into our privacy policies. However, no assurances can be made that a breach of such measures will not occur, and a major breach of customer privacy or security could have serious consequences for our Internet-based operations. Use of the Internet, particularly for commercial transactions, may not continue to increase as rapidly as it has during the past few years as a result of privacy or security concerns, or for other reasons. If this occurs, the growth of our operations would be materially hindered. If Internet activity becomes heavily regulated in these respects or otherwise, that could also have significant negative consequences for the growth of our current and planned operations.

Our Brokerage Must Meet Net Capital And Other Financial Requirements As A Broker-Dealer That, If Not Satisfied, Could Result In Severe Penalties Or Other Negative Consequences, And Which At All Times Limit Our Right To Use All Of The Brokerage’s Cash

The SEC, the NASD, the CFTC, the NFA, the DTCC (i.e., NSCC and DTC), certain exchanges and other regulatory and self-regulatory agencies or organizations have stringent rules with respect to the maintenance of specific levels of net capital by securities broker-dealers and futures commission merchants, large, fluctuating cash deposit requirements, and reserve, settlement and other financial requirements. Net capital is the net worth of the regulated company (assets minus liabilities), less deductions for certain types of assets as well as other charges. If a firm fails to maintain the required net capital it may be subject to suspension or revocation of registration by the SEC or CFTC and suspension or expulsion by the NASD or NFA, and it could ultimately lead to the firm’s liquidation. If such net capital rules are changed or expanded, or if there is an unusually large charge against net capital, operations that require the use of capital would be restricted. Also, our ability to withdraw capital from our TradeStation Securities brokerage subsidiary is subject to SEC rules, which in turn could materially impact our available working capital and materially impact or limit our ability to repay debt as and when due, redeem or purchase shares of our outstanding stock, if required or desirable, and pay dividends in the future. A large operating loss or charge against net capital could adversely affect our ability to expand or even maintain our then present levels of business, which could have a material adverse effect on our business, financial condition, results of operations and prospects. See “We May Need Cash In The Foreseeable Future” above.

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Control Of TradeStation Group By The Cruzes Means That Important Decisions Affecting The Company Are Concentrated In The Judgment Of Two Related Individuals

As of February 28, 2005, affiliates of William R. Cruz and Ralph L. Cruz (the Co-Chairmen and Co-Chief Executive Officers of our company) own over 47% of the outstanding shares of our common stock. Therefore, as a practical matter, the Cruzes control TradeStation Group. Any and all decisions and votes of our shareholders (including the election of our Board of Directors and any merger, consolidation or sale of all or substantially all of TradeStation Group’s assets) will likely be determined by the Cruzes.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk generally represents the risk of loss that may result from the potential change in the value of a financial instrument as a result of fluctuations in interest rates and market prices. We have established policies, procedures and internal processes governing our management of market risks in the normal course of our business operations. We do not hold any market risk sensitive instruments for trading purposes.

TradeStation Securities seeks to control the risks associated with our customer activities by requiring customers to maintain margin collateral and reduce concentrated positions in compliance with regulatory and internal guidelines. TradeStation Securities monitors required margin levels on an intra-day basis and, pursuant to such guidelines, requires customers to deposit additional collateral, or to reduce positions, when necessary.

TradeStation Securities earns interest from interest revenue sharing arrangements with its clearing agents and as a self-clearing broker-dealer, holds interest earning assets, mainly funds required to be segregated in compliance with federal regulations for customers. These funds totaled $347.1 million at December 31, 2004. Interest earning assets are financed primarily by short-term interest bearing liabilities, totaling $420.7 million at December 31, 2004, in the form of customer cash balances. TradeStation Securities earns a net interest spread on the difference between amounts earned on customer margin loans and amounts paid on customer cash balances. Because TradeStation Securities establishes the rate paid on customer cash balances and the rate charged on customer margin loans, a substantial portion of our interest rate risk is under our direct management. We estimate that, based upon our brokerage customer balances as of the date of this report, for each basis point increase or decrease in interest rates retained by the company there is an annual impact of approximately $25,000 to our net income after income taxes.

Changes in interest rates also affect the interest earned on our cash and cash equivalents. In order to reduce this interest rate risk, we are currently invested in investments with short maturities. As of December 31, 2004, our cash and cash equivalents consist primarily of interest bearing cash deposits and money market funds. Any increase or decrease in interest rates will not have a material impact on our interest earned on our corporate cash balances.

TradeStation Securities seeks to control risks associated with its securities borrowing activities by requiring credit approvals for counterparties, by monitoring the collateral values for securities borrowed on a daily basis and by obtaining additional collateral as needed. See Note 17 of Notes to Consolidated Financial Statements – COMMITMENTS AND CONTINGENCIES – General Contingencies and Guarantees.

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Our revenues and financial instruments are denominated in U.S. dollars, and we do not invest in derivative financial instruments.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The Consolidated Financial Statements and notes thereto and the reports of the independent registered public accounting firm set forth on pages F-1 through F-31 are filed as part of this report and incorporated herein by reference.

The Consolidated Financial Statement Schedule and the report of the independent registered public accounting firm set forth on pages S-1 through S-3 are filed as part of this report and incorporated herein by reference.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

Not applicable.

ITEM 9A. CONTROLS AND PROCEDURES

As of the end of the period covered by this report, an evaluation of the effectiveness of the design and operation of the company’s disclosure controls and procedures was made under the supervision and with the participation of the company’s management, including the Co-Chief Executive Officers and the Chief Financial Officer. Based on that evaluation, the company’s management, including the Co-Chief Executive Officers and the Chief Financial Officer, concluded that the company’s disclosure controls and procedures have been designed and are being operated in a manner that provides reasonable assurance that the information required to be disclosed by the company in reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. A system of controls, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the system of controls are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.

See pages F-2 through F-4 of the Consolidated Financial Statements for the Report of Management on Internal Control Over Financial Reporting and the related Report of Independent Registered Public Accounting Firm, each of which are filed as part of this report and incorporated herein by reference.

There have been no changes in the company’s internal controls over financial reporting that occurred during the fourth quarter of 2004 that have materially affected, or are reasonably likely to materially affect, the company’s internal controls over financial reporting.

ITEM 9B. OTHER INFORMATION

Not applicable.

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PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Directors and Executive Officers

The executive officers and directors of TradeStation Group and their respective ages and positions as of February 28, 2005 are as follows: