TRADESTATION GROUP INC - Quarter Report: 2005 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2005

OR

For the transition period from             to             

Commission file number 0-31049

TradeStation Group, Inc.

(Exact name of registrant as specified in its charter)

8050 S.W. 10^th 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  ¨

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of November 1, 2005, there were 43,409,728 shares of the Registrant’s Common Stock outstanding.

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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

(Unaudited)

See accompanying notes.

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TRADESTATION GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

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 and nine months ended September 30, 2005 and 2004 are unaudited)

(1) NATURE OF OPERATIONS AND BASIS OF PRESENTATION

TradeStation Group, Inc. (the “Company”) 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 is a securities broker-dealer and futures commission merchant. TradeStation Technologies develops and offers strategy trading software tools and subscription services.

The accompanying consolidated financial statements include the results of the Company and its subsidiaries, all of which are wholly owned. All intercompany accounts and transactions have been eliminated.

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, 2004. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) necessary to present fairly the Company’s consolidated financial position as of September 30, 2005 and the consolidated results of operations and cash flows for each of the periods presented have been recorded. Certain prior period amounts have been reclassified to conform to the current period presentation as a result of the Company commencing self-clearing of equities trades for its active trader client base in September 2004 and the related increase of brokerage interest income and interest expense in 2005. 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.

Recently Issued Accounting Standards

In May 2005, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 154, Accounting Changes and Error Corrections, which is a replacement of Accounting Principles Board (“APB”) Opinion No. 20, Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS 154 provides guidance on accounting for and reporting of accounting changes and error corrections. It requires a voluntary change in accounting principle to be applied retrospectively to all prior periods’ financial statements as if the principle had always been applied. Previously, voluntary changes in accounting principles were required to be recognized by including, in net income of the period of change, the cumulative effect of changing to the new accounting principle. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company presently has no plans to adopt a voluntary change in accounting principle, and is not aware of any errors in its financial statements that would require correction; therefore, the Company believes that the adoption of SFAS No. 154 will not have an effect on the Company’s consolidated financial statements.

In December 2004, the 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. In April 2005, the Securities and Exchange Commission (“SEC”) announced a deferral of the effective date of SFAS 123(R) for calendar year companies until the beginning of 2006. The Company expects to adopt SFAS 123(R) on January 1, 2006, but has not yet determined if it will use the modified-prospective method or the modified-retrospective

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method. As permitted by SFAS No. 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 the Company’s consolidated results of operations, although it will have no impact on the Company’s overall consolidated 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 the Company adopted SFAS 123(R) in prior periods, the impact of that standard would have been approximately as described in the disclosure of pro forma net income and earnings per share in Note 2 – STOCK BASED COMPENSATION – PRO FORMA NET INCOME. SFAS 123(R) also requires the benefits of tax deductions in excess of recognized compensation costs 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 as a result of tax deductions in excess of recognized compensation costs during the nine months ended September 30, 2005 and 2004 was approximately $3.7 million and $3.6 million, respectively.

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

In accordance with SFAS No. 123, 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. There were no stock-based transactions with non-employees during the nine months ended September 30, 2005 or 2004; therefore, no such compensation expense was recorded.

As currently permitted by SFAS No. 123, the Company accounts for its stock-based transactions with employees using the intrinsic value method proscribed by APB Opinion No. 25. Under this method, compensation is generally not required to be recognized 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 pro forma effect on net income and earnings per share as if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee transactions.

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

(4) 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. Comprehensive income equals net income for all periods presented.

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(5) RECEIVABLES FROM BROKERAGE CUSTOMERS, NET

Receivables from brokerage customers, net, consist primarily of margin loans to TradeStation Securities’ brokerage customers of $60.7 million (net of a $221,000 allowance for a potential credit loss) and $57.0 million (net of a $209,000 allowance for a potential credit loss) at September 30, 2005 and December 31, 2004, respectively. Securities owned by brokerage customers are held as collateral for margin loans. Such collateral is not reflected in the consolidated financial statements. At September 30, 2005 and December 31, 2004, TradeStation Securities was charging a base margin debit interest rate of 8.125% and 6.375% per annum, respectively, on debit balances in brokerage customer accounts.

“Margin” requirements determine the amount of equity required to be held in an account for the purchase of equities on credit. Margin lending is subject to the margin rules of the Board of Governors of the Federal Reserve System, the margin requirements of the National Association of Securities Dealers (“NASD”), limits imposed by clearing agent firms, and TradeStation Securities’ own internal policies. By permitting customers to purchase and maintain securities positions on margin, TradeStation Securities takes the risk that a market decline will reduce the value of the collateral securing its margin loan to an amount that renders the margin loan unsecured. Under applicable securities laws and regulations, once a margin account has been established, TradeStation Securities is obligated to require from the customer initial margin of no lower than 50% for purchases of securities and then is obligated to require the customer to maintain its equity in the account equal to at least 25% of the value of the securities in the account. However, TradeStation Securities’ current internal requirement is that the customer’s equity not be allowed to fall below 35% of the value of the securities in the account. If it does fall below 35%, TradeStation Securities requires the customer to increase the account’s equity to 35% of the value of the securities in the account (if not, TradeStation Securities will perform closing transactions to bring the customer account above the maintenance requirement). These requirements can be, and often are, raised as TradeStation Securities deems necessary for certain accounts, groups of accounts, securities or groups of securities. However, there is no assurance that a customer will be willing or able to satisfy a margin call or pay unsecured indebtedness owed to TradeStation Securities.

In September 2004, a sudden, adverse price movement in a stock for which a brokerage client account held a concentrated short position resulted in an unsecured net debit in that account of approximately $207,000 (subsequent interest charges have been recorded). TradeStation Securities has filed an NASD arbitration demand to try to collect this unsecured debit, but no assurance can be given that any of this unsecured debit will be collected. At September 30, 2005 and December 31, 2004, a full allowance was recorded for this unsecured debit (including subsequent interest charges). See Note 10 – COMMITMENTS AND CONTINGENCIES – General Contingencies and Guarantees.

(6) RECEIVABLES FROM BROKERS, DEALERS, CLEARING ORGANIZATIONS AND CLEARING AGENTS

Amounts receivable from brokers, dealers, clearing organizations and clearing agents consist of the following as of September 30, 2005 and December 31, 2004:

Securities borrowed transactions require TradeStation Securities to provide the counterparty with collateral in the form of cash and are recorded at the amount of cash collateral advanced to the lender. TradeStation Securities monitors the market value of securities borrowed on a daily basis, and collateral is adjusted as necessary based upon market prices. See Note 10 – COMMITMENTS AND CONTINGENCIES – General Contingencies and Guarantees.

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TradeStation Securities services its institutional equities accounts through Bear, Stearns Securities Corp. on a fully-disclosed basis. Futures trades are cleared through R.J. O’Brien & Associates, and forex trades, through July 15, 2005, were cleared through R.J. O’Brien Foreign Exchange, each on a fully-disclosed basis. Subsequent to July 15, 2005, forex trades have been cleared through Gain Capital Group, Inc. on a fully-disclosed basis (Bear, Stearns Securities Corp., R.J. O’Brien & Associates, R.J. O’Brien Foreign Exchange, and Gain Capital Group, Inc. are collectively referred to as “clearing agents” or “clearing agent firms”). These clearing agents provide services, handle TradeStation Securities’ customers’ funds, hold securities, futures and forex positions, and remit monthly activity statements to the customers on behalf of TradeStation Securities.

(7) PAYABLES TO BROKERS, DEALERS AND CLEARING ORGANIZATIONS

Amounts payable to brokers, dealers and clearing organizations consist of the following as of September 30, 2005 and December 31, 2004:

(8) PAYABLES TO BROKERAGE CUSTOMERS

Amounts payable to brokerage customers consist of the following as of September 30, 2005 and December 31, 2004:

Cash balances in brokerage customer accounts are the principal source of funding for margin lending. At September 30, 2005 and December 31, 2004, TradeStation Securities was paying interest at a rate of 1.125% and 0.75% per annum, respectively, on cash balances in excess of $10,000 in brokerage customer accounts.

(9) NET CAPITAL REQUIREMENTS

TradeStation Securities is subject to the net capital requirements of the SEC’s Uniform Net Capital Rule (Rule 15c3-1) and the Commodity Futures Trading Commission’s financial requirement (Regulation 1.17). TradeStation Securities calculates its net capital requirements using 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 September 30, 2005, TradeStation Securities had net capital of approximately $31.1 million (32.8% of aggregate debit items), which was approximately $29.2 million in excess of its required net capital. 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.

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(10) COMMITMENTS AND CONTINGENCIES

Restricted Cash

At September 30, 2005 and December 31, 2004, the Company had $1.7 million and $1.9 million of restricted cash, respectively, supporting a ten-year lease agreement for its corporate headquarters.

Line of Credit and Guarantee

In June 2005, TradeStation Securities entered into a loan agreement for a revolving credit facility which the Company has guaranteed. The revolving credit facility provides for borrowings up to $10 million, expires on its first anniversary (June 16, 2006) if not renewed, and is payable on demand. The credit facility is available for TradeStation Securities’ short-term working capital needs. Borrowings under the credit facility bear interest at the LIBOR Market Index Rate plus 1.7%, (5.6% as of September 30, 2005) and the outstanding balance must be paid down to a maximum balance of $1,000 on at least five days each month. Accrued interest is payable monthly. There is an unused line of credit fee equal to 25 basis points per annum on the average daily unused available principal balance for the preceding calendar quarter, which shall be waived if the Company and/or any of its subsidiaries maintain, in the aggregate, on average during a quarterly period, over $1 million of deposits with the counter-party during the first year and, if renewed, over $10 million thereafter. There have not been any borrowings under this line of credit and the Company has not incurred any unused line of credit fees.

Operating Leases

The Company has 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. Rent escalations, free rent, and leasehold and other incentives are recognized on a straight-line basis over the initial term of this lease.

In addition to its corporate headquarters, the Company has four non-cancelable operating leases for facilities (including two data centers) with expirations ranging from April 2006 to July 2007. In addition to the leases for facilities, the Company leases certain office equipment. Future minimum lease payments as of September 30, 2005, under all operating leases, are as follows:

Total rent expense for the three months ended September 30, 2005 and 2004 was approximately $765,000 and $776,000, respectively. Total rent expense for the nine months ended September 30, 2005 and 2004 was approximately $2.4 million and $2.7 million, respectively.

Purchase Obligations

As of September 30, 2005, the Company had various purchase obligations through September 2007 of approximately $482,000, $1.1 million and $490,000 for the remainder of 2005, 2006 and 2007, respectively, related primarily to back office systems and telecommunications services.

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Litigation and Claims

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 Tafazzoli/zum Tobel case is in the discovery phase of litigation, the Gambino case is near the end of the discovery phase, and, in the Allen case, motions for summary judgment have been filed by both the plaintiffs and defendants. The Company continues to believe all of the claims in all three cases are baseless.

TradeStation Securities is also engaged in routine regulatory matters and civil litigation or other dispute resolution proceedings, including matters relating to NASD OATS reporting, NYSE OTS reporting, short sales procedures, and NASD arbitrations, incidental to, and part of the ordinary course of, its business. The OATS reporting, OTS reporting and short sale procedures matters could ultimately result in censures and fines. As of the date of the Company’s last quarterly report, three NASD arbitrations were pending against the Company seeking, in the aggregate, tens of millions of dollars of actual and punitive damages. In one of those cases, the arbitrators awarded the claimants $196,000 (inclusive of interest) and in another of those cases the claims were settled for $100,000. The remaining pending arbitration is set for hearing in January 2006, and the Company believes the claims made in that case are baseless.

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.

Beginning June 1, 2002, the Company has not carried 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 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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General Contingencies and Guarantees

In the ordinary course of business, there are various contingencies which are not reflected in the consolidated financial statements. These include customer activities involving the execution, settlement and financing of various customer securities and futures transactions. These activities may expose the Company to off-balance sheet credit risk in the event the customers are unable to fulfill their contractual obligations.

In margin transactions, TradeStation Securities may be obligated for credit extended to its customers by TradeStation Securities or its clearing agents that is collateralized by cash and securities in the customers’ accounts. 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’ 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. 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 manage 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. For further discussion, see Note 5 – RECEIVABLES FROM BROKERAGE CUSTOMERS, NET.

TradeStation Securities borrows securities temporarily from other broker-dealers in connection with its broker-dealer business. TradeStation Securities deposits cash as collateral for the securities borrowed. Decreases in securities prices may cause the market value of the securities borrowed to fall below the amount of cash deposited as collateral. In the event the counterparty to these transactions does not return the cash deposited, TradeStation Securities may be exposed to the risk of selling the securities at prevailing market prices. TradeStation Securities seeks to manage this risk by requiring credit approvals for counterparties, by monitoring the collateral values on a daily basis, and by requiring additional collateral as needed.

The customers’ financing and securities settlement activities may require TradeStation Securities and its clearing agents to pledge customer securities as collateral in support of various secured financing sources, which may include bank loans. 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 obligations. TradeStation Securities seeks to manage this risk by monitoring the market value of securities pledged on a daily basis.

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 or exchange, 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.

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(11) INCOME TAXES

During the three and nine months ended September 30, 2005, the Company recorded an income tax provision of $3.6 million and $8.5 million, respectively, based upon its current estimated annual effective income tax rate of approximately 38%, certain deferred income tax net adjustments and final reconciliation of the Company’s 2004 federal and state income tax returns. During the three and nine months ended September 30, 2004, the Company recorded an income tax provision of $1.1 million and an income tax net benefit of $2.1 million, respectively. In 2004, income taxes were based upon an estimated annual effective income tax rate of 37%. For the nine months ended September 30, 2004, the income tax provision was more than offset by the reversal of a significant portion of a valuation allowance on deferred income tax assets (see below).

As of September 30, 2005 and December 31, 2004, the Company had net deferred income tax assets of $1.2 million and $3.8 million, respectively, which included a valuation allowance of $926,500 as of both dates. 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. In June 2004, the Company reversed a significant portion of the valuation allowance that was previously provided on its deferred income tax assets, because, in the opinion of management, it was more likely than not that those benefits would 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 June 2004 decision to reverse a significant portion of the valuation allowance was based on several factors, including TradeStation Securities receiving final approval of the Depository Trust & Clearing Corporation to begin self-clearing for equities, the rollout of TradeStation 8 (which included integrated options execution), and eight consecutive quarters of income from operations. In the 2004 second quarter, the result of this reversal was an income tax net 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 September 30, 2005, the Company estimates, for federal income tax purposes, that it has net operating loss carryforwards of approximately $3.0 million (expiring in 2019) and income tax credits of approximately $124,000 (expiring in 2010 through 2019) related to a 1999 acquisition. Since the deferred income tax assets related to these net operating loss carryforwards and income tax credits are subject to annual usage limitations of $545,000, the Company continues to maintain a $926,500 valuation allowance pertaining to these assets. The valuation allowance represents approximately the last five years of the annual limitation amount, due to the Company’s inability to estimate taxable income that far into the future. Additionally, for Florida state income tax purposes, as of September 30, 2005, the Company estimates that it has net operating loss carryforwards of approximately $3.2 million (expiring in 2020 through 2023), of which the benefit has been recorded through additional-paid-in capital (relating to the tax benefit of stock option exercises).

In April 2005, a letter from the Internal Revenue Service was received notifying the Company that its federal income tax return for the year ended December 31, 2003 has been selected for examination. Management believes this examination, which is currently in progress, to be a routine examination in the ordinary course. While no assurances can be given, the Company believes that this examination will not have a material impact on the Company’s financial position or results of operations.

(12) SEGMENT AND RELATED INFORMATION

For the three and nine months ended September 30, 2005 and 2004, 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.

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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 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 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, equity 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 equity 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.

TradeStation Securities’ brokerage revenues consist of transactional commissions and fees, interest derived from customer balances and margin lending to customers, and monthly platform fees. Given the growth of customer accounts, customer account balances and the rise in interest rates over the past several months, we now report interest income separately as a component of brokerage revenues. With respect to monthly platform fees (a $99.95 charge made to less active brokerage customers for being granted access to use the TradeStation trading platform), effective September 1, 2005 we launched a strategic marketing initiative which reduced materially the trading activity thresholds that need to be met to qualify for a waiver of the monthly platform fee. During September 2005, this threshold reduction decreased monthly revenues by approximately $250,000 and monthly net income by approximately $155,000. No assurances can be given that material offsetting benefits will be achieved.

We recently launched two other strategic marketing initiatives (each to be effective December 1, 2005) designed mainly to accelerate growth in our futures business. The first initiative, designed to attract high-volume futures traders, is the change from our current one-price-fits-all futures commission

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structure to a tiered commission structure that rewards more active traders with lower pricing. Under this new pricing structure, the commission that will be charged over the applicable exchange fee will range from $1.20 down to 25 cents per contract (per side). Also, we currently charge an all-in-one futures commission that includes both exchange and brokerage fees. Under the new plan, these charges will be unbundled, so that the customer will pay the applicable exchange fees for the contracts traded, plus the tiered TradeStation fees applicable to that customer. This will enable customers to see how much each exchange charges for trades, and to better understand and take advantage of reduced fees for exchange members. The second initiative is to further reduce the trading activity thresholds futures, forex and equity options customers need to meet to qualify for a waiver of the monthly platform fee. These two marketing initiatives, assuming no offsetting benefits, are estimated to reduce monthly revenues by approximately $310,000 and monthly net income by approximately $200,000, beginning in December 2005. No assurances can be given that material offsetting benefits will be achieved for either of these new initiatives.

Prior to September 2004, all equities trades were cleared through Bear, Stearns Securities Corp. Beginning in September 2004, TradeStation Securities commenced equities self-clearing operations for its active trader client base and commenced omnibus clearing of its standardized equity option trades through Broadcort, a division of Merrill Lynch. Beginning March 29, 2005, following issuance of its membership in the OCC, TradeStation Securities commenced full self-clearing of its standardized equity options trades for its active trader client base. Self-clearing has provided substantial cost savings and efficiencies. TradeStation Securities continues to clear institutional account securities trades through Bear, Stearns Securities Corp. on a fully-disclosed basis. Futures trades are cleared through R.J. O’Brien & Associates, and forex trades, through July 15, 2005, were cleared through R.J. O’Brien Foreign Exchange, each on a fully-disclosed basis. Subsequent to July 15, 2005, forex trades have been cleared through Gain Capital Group, Inc. on a fully-disclosed basis (Bear, Stearns Securities Corp., Broadcort, R.J. O’Brien & Associates, R.J. O’Brien Foreign Exchange, and Gain Capital Group, Inc. are collectively referred to as “clearing agents” or “clearing agent firms”). In connection with a recent extension of its futures clearing agreement (which was set to expire December 31, 2005) and a recent agreement with its new forex clearing agent, TradeStation Securities began receiving in July 2005 materially more favorable interest-sharing and clearing fee/deal-spread sharing arrangements. These benefits are not based on growth in trading volume or any other contingency.

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 (for stocks) and the OCC (for options); 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.

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As of September 30, 2005, TradeStation Securities had 22,341 equities, futures and forex accounts (the vast majority of which were equities and futures accounts), an increase of 35%, as compared to 16,496 accounts as of September 30, 2004. The following table presents, for the periods indicated, certain brokerage metrics and account information:

We compute DARTs as follows: For equities and equity options, a revenue trade included to calculate DARTs is a commissionable trade order placed by the customer and executed, regardless of the number of shares or contracts included in the trade order. For futures and forex, a revenue trade included to calculate DARTs is one round-turn commissionable futures contract traded, or one round-turn lot (or forex deal) traded, regardless of the number of individual orders made and executed (i.e., one futures or forex order may contain numerous contracts or deals, but each round-turn contract and deal is counted as a separate revenue trade). When viewing our DARTs, it should be taken into account that, for equities and equity options, we charge commissions based on share volume and number of contracts traded (and not by revenue trade used to calculate DARTs). For futures, we charge commissions on a per contract basis (so each futures revenue trade included to calculate DARTs represents a round-turn commissionable contract traded). It should be noted that as we continue to acquire futures customers who trade larger volumes, and seek to accelerate our acquisition of higher-volume futures accounts, such as futures traders who may be attracted by our new tiered commission pricing structure and institutional traders, the number of futures revenues trades included in DARTs on a per order basis will likely grow. Also, it should be noted that all DARTs are not equal. The revenue we derive from each revenue trade depends on the asset in question (equities, equity options, futures, forex – each has a different per unit revenue structure), and, within each asset class, revenue per equity, contract or deal varies to the extent higher volume traders receive more favorable pricing, which they often do.

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.

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Results of Operations

For the three months ended September 30, 2005 and 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. The following table presents, for the periods indicated, certain items in our consolidated statements of income broken down by segment: