TRADESTATION GROUP INC - Quarter Report: 2004 March (Form 10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the transition period from ____________________ to _____________________

Commission file number 0-31049

TradeStation Group, Inc.

8050 S.W. 10th Street, Suite 4000, Plantation, Florida 33324
(Address of principal executive offices)
(Zip Code)

954-652-7000
(Registrant’s telephone number, including area code)

     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    o

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

     As of April 30, 2004, there were 41,616,323 shares of the Registrant’s Common Stock outstanding.

Table of Contents

TRADESTATION GROUP, INC. AND SUBSIDIARIES

INDEX

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PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

TRADESTATION GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

See accompanying notes.

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TRADESTATION GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

See accompanying notes.

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TRADESTATION GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

See accompanying notes.

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TRADESTATION GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(All notes and related disclosures applicable to
the three months ended March 31, 2004 and 2003 are unaudited)

     TradeStation Group, Inc. (the “Company”), 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 offers the TradeStation platform to institutional, professional and serious, active individual traders. TradeStation is an electronic trading platform that enables clients to design, test and monitor their own custom trading strategies and then automate them with direct-access order execution. The trading platform currently offers streaming real-time equities, options, futures and forex market data. TradeStation Technologies develops and offers strategy trading software tools and subscription services, and owns and operates the TradeStationWorld.com strategy trading and development community.

     The accompanying consolidated financial statements should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included in the Annual Report on Form 10-K of TradeStation Group for the year ended December 31, 2003. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) necessary to present fairly the consolidated financial position as of March 31, 2004 and the consolidated results of operations and cash flows for the three months ended March 31, 2004 and 2003 have been recorded. The results of operations and cash flows for an interim period are not necessarily indicative of the results of operations or cash flows that may be reported for the year or for any subsequent period. Certain prior period amounts have been reclassified to conform to the current period presentation.

(1) EARNINGS PER SHARE

     Weighted average shares outstanding for the three months ended March 31, 2004 and 2003 are calculated as follows:

     Stock options and warrants outstanding for the three months ended March 31, 2004 and 2003, which are not included in the calculation of diluted earnings per share because their impact is antidilutive, are as follows:

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(2) STOCK-BASED COMPENSATION – PRO FORMA NET INCOME

     In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, in accounting for stock-based transactions with non-employees the Company records compensation expense in the statement of income when such equity instruments are issued. No such compensation expense was recorded for the three months ended March 31, 2004 or 2003.

     As permitted by SFAS No. 123, the Company accounts for its stock-based compensation paid to employees using the intrinsic value method in accordance with the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Generally, no stock-based employee compensation cost is reflected in net income, as all 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.

     The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation.

     The fair value of each option grant is estimated on the date of grant using the Black-Scholes model with the following assumptions:

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(3) COMPREHENSIVE INCOME

     Comprehensive income is defined as the change in a business enterprise’s equity during a period arising from transactions, events or circumstances relating to non-owner sources, such as unrealized gains or losses on available-for-sale securities and foreign currency translation adjustments. It includes all changes in equity during a period except those resulting from investments by, or distributions to, owners. The Company held an investment in corporate stock during 2003, classified as an available-for-sale security, at market value. Temporary unrealized holding losses have been excluded from earnings and are reported in comprehensive income.

     A reconciliation of net income to comprehensive income is as follows:

(4) ACCRUED EXPENSES

     Accrued expenses consist of the following as of March 31, 2004 and December 31, 2003:

     “Other” includes commissions to third parties, returns and other accrued expenses and reserves, none of which individually exceeds 5% of total liabilities.

(5) NET CAPITAL REQUIREMENTS

     TradeStation Securities is subject to the net capital requirements of the Securities and Exchange Commission’s Uniform Net Capital Rule (Rule 15c3-1) and the Commodity Futures Trading Commission’s financial requirement (Regulation 1.17). To satisfy each requirement, TradeStation Securities is required to maintain net capital equal to the greater of $250,000 or 1/15th of aggregate indebtedness. Also, the ratio of aggregate indebtedness to net capital cannot exceed 15 to 1. As of March 31, 2004, TradeStation Securities had net capital of $12.1 million, which was $11.7 million in excess of its required net capital of $411,000, and a ratio of aggregate indebtedness to net capital of 0.51 to 1. As of December 31, 2003, TradeStation Securities had net capital of $11.3 million, which was $10.9 million in excess of its required net capital of $415,000, and a ratio of aggregate indebtedness to net capital of 0.55 to 1.

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(6) SEGMENT AND RELATED INFORMATION

     For the three months ended March 31, 2004 and 2003, TradeStation Group operated in two principal business segments: (i) brokerage services; and (ii) software products and services. The Company evaluates the performance of its segments based on revenue and operating income. The brokerage services segment represents the operations of TradeStation Securities and the software products and services segment represents the operations of TradeStation Technologies. All intercompany transactions are eliminated in consolidation.

(7) COMMITMENTS AND CONTINGENCIES

     Restricted Cash

     As of March 31, 2004, the Company had $2.7 million of restricted cash, broken down as follows: (i) $2.2 million of cash supporting a ten-year lease agreement; and (ii) $567,000 of cash reserved for the benefit of certain customers.

     Litigation & Claims

     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 are 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 alleges 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. The lawsuit seeks injunctive relief, actual damages and attorneys’ fees. The Company believes Datamize’s claim is baseless and intends to defend itself vigorously.

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     Three lawsuits have been filed by former principal owners of onlinetradinginc.com corp. (the predecessor of TradeStation Securities) against the Company, certain of its directors and 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. The Company believes all of the allegations are baseless, intends to defend itself and the other named parties vigorously in court, and expects to prevail in each of the lawsuits.

     On February 11, 2003, the plan administrator appointed under the reorganization plan in the Chapter 11 bankruptcy of Bridge Information Systems, Inc. and its affiliates filed an adversary complaint against TradeStation Technologies and the Company in the United States Bankruptcy Court for the Eastern District of Missouri demanding that the Company and TradeStation Technologies return payments made to TradeStation Technologies by a Bridge subsidiary in December 2000 and January 2001 totaling approximately $1.0 million, claiming such payments were preferential transfers under the federal bankruptcy code as a result of being made to TradeStation Technologies during the ninety-day period immediately preceding the Chapter 11 bankruptcy filing. The Company believes this claim to be without merit on various grounds and intends to vigorously defend this claim.

     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 (claims in pending arbitrations seek, in the aggregate, tens of millions of dollars of actual and punitive damages).

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

     The Company decided, as of June 1, 2002, to no longer carry errors or omissions insurance that covers third-party claims made by brokerage clients or software subscribers as a result of alleged human or system errors, failures, acts or omissions. This decision was made based upon the Company’s 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 the Company’s business.

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     Contractual Obligations

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

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     This discussion should be read in conjunction with the Consolidated Financial Statements and the Notes to Consolidated Financial Statements of TradeStation Group and its subsidiaries contained herein. The results of operations for an interim period are not necessarily indicative of results for the year, or for any subsequent period.

Overview and Recent Developments

     TradeStation Securities, a leading direct-access brokerage firm serving the active trader and certain institutional trader markets, is the company’s principal operating subsidiary. TradeStation Securities is a licensed broker-dealer and futures commission merchant, and a member of the National Association of Securities Dealers (NASD), Securities Investor Protection Corporation (SIPC), National Futures Association (NFA), American Stock Exchange (AMEX), Archipelago Exchange (ArcaEx or ARCX), Boston Options Exchange (BOX), Chicago Board Options Exchange (CBOE), International Securities Exchange (ISE), Pacific Stock Exchange (PCX), and Philadelphia Stock Exchange (PHLX), and has a pending membership application with the New York Stock Exchange (NYSE).

     As of March 31, 2004, TradeStation Securities had 13,723 equities, futures and forex accounts, the vast majority of which were equities and futures accounts, as compared to 8,918 accounts as of March 31, 2003. During the 2004 first quarter, TradeStation Securities’ brokerage client account base had 33,877 daily average revenue trades, as compared to 17,235 during the 2003 first quarter.

     In March 2004, we launched the roll-out of TradeStation 8.0, which includes fully-integrated, direct-access options execution. The roll-out of TradeStation 8.0 is being completed this month.

     We continue to work towards commencing self-clearing operations for our active trader equities brokerage services. In April 2004, we announced that our application is not likely to be acted upon until the Depository Trust & Clearing Corporation’s (DTCC) anticipated June 2004 committee meeting, which would mean the earliest start date for self-clearing would be late August 2004.

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

Results of Operations

     For the three months ended March 31, 2004 and 2003, 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. All intercompany transactions are eliminated in consolidation. The following table presents, for the periods indicated, certain items in our consolidated statements of income broken down 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 the Annual Report on Form 10-K of TradeStation Group for the year ended December 31, 2003 – 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.

     Brokerage Revenues. Brokerage revenues are the key component of our results of operations and are comprised primarily of brokerage commissions and fees earned from our clients’ brokerage transactions and, to a lesser extent, platform fees earned from brokerage customers using the TradeStation electronic trading platform and interest earned from interest revenue sharing arrangements with the brokerage’s clearing firms. Brokerage commissions and fees and their related clearing costs are recorded on a trade date basis as transactions occur. Platform fees and interest are recorded monthly, when earned.

     Income Taxes. We have net deferred income tax assets of $7.6 million which are offset by a valuation allowance of $7.6 million (the full amount) in accordance with the requirements of Statement of Financial Accounting Standards (“SFAS”) No. 109, Accounting for Income Taxes. Management evaluates and determines, on a periodic basis, if the amount of the valuation allowance should be adjusted. Of this $7.6 million, $3.4 million relate to net operating loss carryforwards the benefit of which may be recorded through additional paid-in capital and not through the consolidated statement of income should realization become more likely than not. See “Income Taxes” below.

     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 clients 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

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substantially different than our estimates. During the quarter ended March 31, 2004, we reversed $569,000 of our accruals related to a third-party claim which has been inactive for over one year. During the prior year quarter ended March 31, 2003, we reduced our accruals by approximately $98,000 as a result of the settlement of a claim for an amount lower than the amount we estimated. See "Brokerage Services Segment – Operating Expenses – General and Administrative.”

Three Months Ended March 31, 2004 and 2003

Overall

     Total revenues were $17.5 million for the three months ended March 31, 2004, as compared to $13.3 million for the three months ended March 31, 2003, an increase of $4.2 million, or 31%, due primarily to an increase in brokerage revenues of $4.1 million.

     Income from operations was $3.5 million for the three months ended March 31, 2004, as compared to $2.2 million for the three months ended March 31, 2003, an improvement of $1.3 million, or 63%. This improvement was due primarily to higher brokerage revenues, net of related clearing and execution costs, partially offset by higher data center costs.

     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 $56,000 for the three months ended March 31, 2004, as compared to $11,000 for the three months ended March 31, 2003. The increase of $45,000 was due primarily to lower interest expense of $27,000 as a result of fewer capital lease obligations, and an increase in interest income of $9,000 as a result of higher average cash balances (partially offset by lower interest rates).

     An income tax provision of $71,000 was recorded during the three months ended March 31, 2004, as compared to an income tax benefit of $87,000 during the three months ended March 31, 2003. See “Income Taxes” below.

Brokerage Services Segment

Revenues

     Brokerage Revenues. Brokerage revenues are comprised primarily of brokerage commissions and fees earned from our clients’ brokerage transactions and, to a lesser extent, platform fees earned from brokerage customers using the TradeStation electronic trading platform and interest earned from interest revenue sharing arrangements with the brokerage’s clearing firms. For the three months ended March 31, 2004, brokerage revenues were $15.1 million (which included brokerage commissions of $11.6 million), as compared to brokerage revenues of $11.0 million (which included brokerage commissions of $8.8 million) for the three months ended March 31, 2003. This $4.1 million increase, or 38%, was due primarily to increased trading activity and platform fees related to brokerage client account growth.

     Effective March 31, 2003, we reduced our commission pricing for futures and options trades and, effective November 1, 2003, we further reduced our commission pricing for futures and our commission pricing per share for equities trades. While we believe these price reductions will have a favorable impact on revenue growth long-term, they may have slowed and may continue to slow our revenue growth in the short- and mid-term. The rate and timing at which these price reductions will, if at all, increase new accounts, client trading activity and/or market share (or continue to increase new accounts, client trading activity and/or market share) is not known. Continued price pressure on online brokerage commissions and fees, as well as our ability to maintain or improve revenue growth, are challenges we expect to continue to face.

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     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 $89,000 for the three months ended March 31, 2004, as compared to $29,000 in the comparable period of the prior year, an increase of $60,000, or 207%. These training workshops were initially offered in the first quarter of 2003.

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. Beginning in 2004, clearing and execution costs include new expenses related to our anticipated self-clearing operations, primarily personnel and related expenses, exchange memberships and consulting expenses, for which we will receive no offsetting cost-savings until self-clearing commences. Clearing and execution costs were $5.7 million for the three months ended March 31, 2004, as compared to $3.5 million for the three months ended March 31, 2003, an increase of $2.2 million, or 63%. This increase was due primarily to increased trading activity related to brokerage client account growth and, to a lesser extent, $450,000 of incremental expenses relating to our anticipated self-clearing operations.

     Clearing and execution costs, as a percentage of brokerage revenues, increased to 38% for the three months ended March 31, 2004, as compared to 32% for the three months ended March 31, 2003, due primarily to costs related to anticipated self-clearing operations and, to a lesser extent, overall price reductions. We believe that clearing costs as a percentage of brokerage revenues will increase in the short-term due to additional increased costs related to our anticipated self-clearing operations. Later in 2004 we expect to begin self-clearing of equities trades for our active trader client base which, while no assurances can be given, we expect will improve our gross margin.

     Data Center Costs. Data center costs are primarily intercompany subscription fees, eliminated upon consolidation, 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 clients and, to a lesser extent, data communications costs necessary to connect our server farms directly to electronic market places. See “Technology Development” below. Data center costs were $4.0 million for both the three months ended March 31, 2004 and 2003. Increased costs to connect our data server farms directly to electronic market places was offset by decreased intercompany subscription fees paid to the software products and services segment. Although there was an increase in the number of brokerage accounts during 2004 as compared to 2003, this was offset by a decrease in the per account intercompany subscription fee charged by TradeStation Technologies to TradeStation Securities. 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 clients and the creation of documentation and other training and educational materials. Technology development expenses for the three months ended March 31, 2004 were $384,000, as compared to $325,000 for the three months ended March 31, 2003, an increase of $59,000, or 18%, 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.”

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     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 $2.4 million for the three months ended March 31, 2004 and for the three months ended March 31, 2003. Sales and marketing expenses are anticipated to increase during future quarters as we explore and possibly implement different marketing initiatives, increase our efforts to grow our institutional trader business, and increase our customer support staff. To better serve our customers, during April 2004, substantially all of the customer support team from the software products and services segment was moved to the brokerage services segment.

     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 $769,000 for the three months ended March 31, 2004, as compared to $937,000 for the three months ended March 31, 2003, a decrease of $168,000, or 18%. This decrease is due primarily to the 2004 first quarter reversal of the uninsured loss provision and related legal fees of $569,000 for a third party claim which has remained inactive for over one year, versus the 2003 first quarter reversal of an uninsured loss provision and related legal fees of $98,000 due to the favorable settlement of a claim. See “Critical Accounting Policies and Estimates – Uninsured Loss Reserves.” This decrease was partially offset by increases in other consulting and professional fees of $190,000 and, to a lesser extent, increases in personnel and related costs, insurance, communication costs and facility costs. General and administrative expenses are anticipated to increase during 2004 due to increased consulting and professional fees (related to increased securities law requirements and ongoing litigation and claims) and higher insurance (primarily the cost of directors’ and officers’ liability and excess-SIPC coverage).

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, 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”). Subscription fees were $5.6 million for the three months ended March 31, 2004 and for the three months ended March 31, 2003. An increase in Intercompany Subscription Fees resulting from increased brokerage accounts at TradeStation Securities was offset by a decrease in the per account Intercompany Subscription Fee charged by TradeStation Technologies to TradeStation Securities. Excluding Intercompany Subscription Fees, subscription fees were $1.9 million for the three months ended March 31, 2004, as compared to $1.7 million for the three months ended March 31, 2003, an increase of $171,000, or 10%, as a result of a price increase to certain groups of subscribers during the second half of 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 consist primarily of royalties and commissions received from third parties whose customers use our legacy software products, and licensing fees derived from direct sales of our legacy client software products. Other revenues were $383,000 for the three months ended March 31, 2004, as compared to $611,000 for the three months ended March 31, 2003, a decrease of $228,000, or 37%. This expected decrease is the result of no longer marketing legacy client software since May 2000 and no longer offering legacy client software products domestically since September 2001. Other revenues are expected to continue to decrease in future quarters.

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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 market places, rent or depreciation for servers, and data distribution and exchange fees. Data center costs for the three months ended March 31, 2004 were $1.3 million, as compared to $1.0 million for the three months ended March 31, 2003, an increase of $273,000, or 27%. The increase is due primarily to increased rent and data communication charges at our facilities of $335,000, partially offset by lower data distribution and exchange fees of $85,000. The decrease in data distribution and exchange fees resulted from increased exchange fees charged to client accounts and receipt of data directly from exchanges (as opposed to a data vendor who is paid monthly fees) beginning during the 2003 fourth quarter, partially offset by incremental costs related to account growth and approximately $136,000 of credits received from our data vendors during the 2003 first quarter.

     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 $1.5 million for the three months ended March 31, 2004 and for the three months ended March 31, 2003.

     Sales and Marketing. We no longer actively market software products and services, the focus of our business being an online brokerage firm for active and institutional traders. Sales and marketing expenses consist primarily of personnel costs for customer support centers and, to a lesser extent, facility costs. Sales and marketing expenses were $229,000 for the three months ended March 31, 2004, as compared to $132,000 for the three months ended March 31, 2003, an increase of $97,000, or 73%, due primarily to a reduction of expenses of $112,000 in the 2003 first quarter as a result of a favorable resolution of an event cancellation dispute. Sales and marketing expenses are expected to decrease during future quarters as substantially all of the customer support team from the software products and services segment moved 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; and insurance. General and administrative expenses were $1.3 million for the three months ended March 31, 2004, as compared to $1.1 million for the three months ended March 31, 2003, an increase of $268,000, or 25%. This increase was due primarily to increased consulting and professional fees of $166,000 and, to a lesser extent, increased insurance and personnel and related costs. General and administrative expenses are anticipated to increase during 2004 due to increased insurance (primarily the cost of directors’ and officers’ liability coverage) and increased consulting and professional fees related to increased securities law requirements and ongoing litigation and claims.

Variability of Quarterly 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, and are likely to vary in the future. Such fluctuations may result in volatility in the price of our common stock. See “Issues, Uncertainties and Risk Factors” below.

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Income Taxes

     At March 31, 2004, we had net deferred income tax assets of $7.6 million, which are offset by a valuation allowance of $7.6 million (the full amount). Of this $7.6 million, $3.4 million relate to net operating loss carryforwards the benefit of which may be recorded through additional paid-in capital and not through the consolidated statement of income should realization become more likely than not.

     As a result of our deferred income tax assets, which include those net operating loss carryforwards, other than alternative minimum tax and state and local income taxes where our net operating loss carryforwards could not be utilized, we have not been obligated to pay income taxes on our earnings since our return to profitability in the second quarter of 2002. During the second quarter of 2004, in accordance with the requirements of SFAS 109, we anticipate making a reversal of all or part of the valuation allowance on our net deferred income tax assets referred to in the previous paragraph, which could generate one-time income of more than $2.0 million in the quarter the reversal is made, and after which we will begin to record income tax expense at an effective rate of 37.6%.

     During the three months ended March 31, 2004, we recorded a net income tax provision of $71,000, most of which was an increase to the valuation allowance established for the amount due under the current year’s alternative minimum tax calculation. Other than the increase to the valuation allowance for the amount due under the current year’s alternative minimum tax calculation and state and local income taxes where our net operating loss carryforwards could not be utilized, the income tax expense associated with net operating income generated during the three months ended March 31, 2004 was totally offset by a reduction to the previously established valuation allowance associated with our deferred income tax assets referred to in the paragraph above, including the net operating loss carryforwards.

     During the three months ended March 31, 2003, we recorded an income tax benefit of $87,000, consisting of (i) a $72,000 refund related to research and development tax credits that arose in connection with an Internal Revenue Service (“IRS”) audit of a prior year’s federal income tax return, and (ii) a $15,000 state income tax refund received for the overpayment of a prior year’s income tax. The income tax expense associated with net operating income generated during the three months ended March 31, 2003 was totally offset by a reduction to the valuation allowance associated with net operating loss carryforwards.

Liquidity and Capital Resources

     As of March 31, 2004, we had cash and cash equivalents of approximately $34.3 million, of which $2.7 million was restricted. Restricted cash supports a facility lease and certain customer agreements. See Note 7 of Notes to Consolidated Financial Statements – COMMITMENTS AND CONTINGENCIES – Restricted Cash.

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

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     In addition to the purchase obligations set forth in the table above, we anticipate, in connection with the expected growth of our brokerage business, capital expenditures of approximately $2.3 million through the remainder of 2004, primarily for the purchase of computer hardware and software. 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. In connection with our plan for TradeStation Securities to begin self-clearing equities trades later in 2004, we will be required to make interest bearing security deposits with clearing corporations, currently estimated to be approximately $10 million.

     Net cash provided by operating activities of $1.5 million during the three months ended March 31, 2004 consisted primarily of net income partially offset by decreases in accrued expenses and increases in receivables from the clearing firms and other assets. Net cash provided by operating activities of $1.6 million during the three months ended March 31, 2003 was due primarily to net income partially offset by decreases in accounts payable and accrued expenses and increases in receivables from the clearing firms.

     Investing activities provided cash of $1.6 million during the three months ended March 31, 2004 mainly due to $2.0 million of proceeds from the maturity of marketable securities, partially offset by capital expenditures (mostly computer hardware and software for our data server farms) and a small increase in restricted cash. Investing activities used cash of $43,000 during the three months ended March 31, 2003, consisting primarily of capital expenditures (mostly computer hardware and software for our data server farms), partially offset by a decrease in restricted cash.

     Financing activities provided cash of $132,000 during the three months ended March 31, 2004, while financing activities used cash of $383,000 during the three months ended March 31, 2003. Proceeds from issuance of common stock from exercises of stock options from our incentive stock plans provided cash of $216,000 and $28,000 during the three months ended March 31, 2004 and 2003, respectively. Repayments of capital lease obligations were $84,000 and $412,000 during the three months ended March 31, 2004 and 2003, respectively.

     During the three months ended March 31, 2004, we issued 1,634 shares of common stock associated with the exercise of warrants in exchange for the delivery and cancellation of 2,800 warrants. As of March 31, 2004, warrants (expiring in June 2004) to purchase up to 62,101 shares of the company’s common stock at $6.73 were outstanding.

Off-Balance-Sheet Arrangements

     TradeStation Securities’ customers’ trading activities are transacted mostly on a margin basis. In margin transactions, TradeStation Securities may be obligated for credit extended to its customers by TradeStation Securities’ clearing firms that is collateralized by cash and securities in the customers’ accounts. In connection with these activities, TradeStation Securities also executes customer transactions involving the sale of securities not yet purchased, substantially all of which are transacted on a margin basis subject to individual exchange regulations. Such transactions may expose TradeStation Securities to significant off-balance-sheet risk in the event margin requirements (i.e., customer collateral) are not sufficient to fully cover losses that customers may incur. In the event the customer fails to satisfy its 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 margin collateral in compliance with its clearing firms’ requirements as well as various regulatory requirements. TradeStation Securities and its clearing firms monitor required margin levels daily and, pursuant to such guidelines, require the customers to deposit additional collateral or to reduce positions when necessary.

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     The customers’ financing and securities settlement activities require TradeStation Securities’ clearing firms to pledge customer securities as collateral in support of various secured financing sources such as bank loans and securities loaned. In the event the counterparty is unable to meet its contractual obligation to return customer securities pledged as collateral, TradeStation Securities may be exposed to the risk of needing to acquire the securities at prevailing market prices in order to satisfy its customers’ obligations. TradeStation Securities controls this risk by monitoring the market value of securities pledged on a daily basis and by requiring adjustments of collateral levels in the event of excess market exposure. In addition, TradeStation Securities establishes credit limits for such activities and monitors compliance on a daily basis.

Issues, Uncertainties and Risk Factors

     The Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations 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,” “believe(s),” “believed,” “could,” “designed,” “estimate,” “estimates,” “estimated,” “expect(s),” “expected,” “expectation(s),” “going forward,” “hopeful,” “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 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. There has been, since mid-year 2000, and, despite improved conditions in 2003 and 2004 there may again be, unfavorable conditions 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, such as has recently occurred, 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 may result in more losses for our clients, which could result in increases in quantity and size of errors or omissions claims that may be made against us by clients. 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.

     We May Need to Make Decisions About When (Or If) We Will Begin Self-Clearing Equity Trades For Active Trader Accounts

     We have planned for some time to begin self-clearing equities trades for our active trader accounts as soon as possible in 2004. Currently, all of our clients’ equities trades are cleared through Bear Stearns, our clearing agent. There can be no assurance that we will obtain all of the approvals and memberships required to conduct self-clearing operations as a broker-dealer. There is also a significant risk that we will encounter substantial delays in launching self-clearing operations due to difficulties in satisfying conditions or requirements attached to membership or approvals (such as requirements regarding large financial or security deposits and other risk management-related issues), or as a result of technical issues or other third-party acts or failures to act outside of our control. In fact, the Depository Trust & Clearing Corporation (DTCC) has very recently expressed some concerns that need to be addressed before we will be considered for approval. While we believe the concerns that have been raised by the DTCC have been fully addressed, there can be no assurance that we will ultimately commence self-clearing operations (for example, we may decide that an omnibus clearing arrangement is more suitable in the circumstances, or that continuing to use a fully-disclosed clearing agent for the foreseeable future is the best decision). If we do commence self-clearing, or an omnibus clearing arrangement, we have no such experience, and the cost savings and efficiencies of self-clearing or omnibus clearing, assuming either occurs, may be less favorable than we expect as a result of unanticipated increased fixed, infrastructure or incremental costs,

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mistakes or other factors. Also, such anticipated savings may be more than offset by account losses or reduced trading activity if any self-clearing mistakes or failures occur which undermine our clients’ or prospects’ confidence in our ability to conduct reliable self-clearing operations.

     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; the timing and market acceptance of new products and services and enhancements developed by our competitors; 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 clients; 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; 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 clients 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 clients 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 of the clearing firms we use, and the forex deal order placement, settlement and back-office systems of or licensed by the forex dealer firm which is responsible for all of our client’s forex trades. Accordingly, our ability to offer a platform that enables the development, testing and automation of trading strategies and the placement and execution 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 firm, exchange and ECN outages or issues which are beyond our control. Also, a hardware or software failure, 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 clients and client prospects

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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.

     The Nature Of Our Business Results In Potential Liability To Customers

     Many aspects of the securities 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 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 data of smaller futures exchanges) 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

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brokerage clients are obtained from established brokerage clearing firms. 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 to quickly change our futures clearing firm in response to a substantial increase in our clearing costs imposed by our former futures clearing firm. We have also decided, due principally to clearing cost considerations, to begin self-clearing active trader equities accounts as soon as possible in 2004. 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 has been an infringement claim asserted against us and eight other online brokerage firms by a company named Datamize, Inc. which would have a material adverse effect on our business, financial condition, results of operations and prospects if it is successful. 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. While we believe Datamize, Inc.’s claim is meritless, no assurances can be made about the outcome of this litigation or the magnitude of the cost to defend the claims made in this litigation.

     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.

     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, currently estimated to be approximately $10 million); 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 clients; substantial legal costs and/or unexpected unfavorable outcomes in lawsuits and arbitrations currently

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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.

     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. 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. 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 currently incorporate and plan to continue to incorporate security measures into our privacy policies. However, 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 Requirements As A Broker-Dealer That, If Not Satisfied, Could Result In Severe Penalties, And Which At All Times Limit Our Right To Use All Of The Brokerage’s Cash

     The SEC, the NASD, the NFA and other regulatory agencies have stringent rules with respect to the maintenance of specific levels of net capital 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 may be subject to suspension or revocation of registration by the SEC or CFTC and suspension

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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 limited. 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.

     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 April 30, 2004, affiliates of William R. Cruz and Ralph L. Cruz (the Co-Chairmen and Co-Chief Executive Officers of our company) own more than 50% of the outstanding shares of our common stock. Therefore, 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 be determined by the Cruzes.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     We are exposed to changes in interest rates. Changes in interest rates affect the interest earned on our cash and cash equivalents, marketable securities and the interest earned from interest revenue sharing arrangements with our clearing firms. In order to reduce this interest rate risk, we are currently invested in investments with short maturities. As of March 31, 2004, our cash and cash equivalents consist primarily of money market funds, U.S. Treasury Bills and obligations of U.S. government agencies. The interest earned on those investments is relatively low based upon current market interest rates. A significant increase in interest rates would have a positive impact on our financial results. Any decrease in those rates would not have a material impact on our financial results.

ITEM 4. CONTROLS AND PROCEDURES

     As of the end of, and with respect to, the period covered by this Quarterly Report on Form 10-Q, 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. There have been no changes in the company’s internal controls over financial reporting that occurred during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the company’s internal controls over financial reporting.

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PART II — OTHER INFORMATION

ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

(c) Sales of Unregistered Securities

     During the three months ended March 31, 2004, we issued to four employees options to purchase an aggregate of 11,500 shares of common stock. Such options vest ratably in annual increments over a five-year period and are exercisable at prices ranging from $9.32 to $10.37 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.

     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. Other than as described above, we did not issue or sell any unregistered securities during the first quarter of 2004.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) The following exhibits are filed as part of this report:

(b) Reports on Form 8-K

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SIGNATURE

     Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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EXHIBIT INDEX

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