How Trading Commission Can Kill Profits
As the number of online brokerages continues to increase at a steady pace and the competition gets fiercer, traders are often targeted with offers ranging from "commission free trading" to "as low as $4,99" brokerage fee advertisements.
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For traders who are starting with a low capital, brokerage fee plays an important role. At the same time, traders who have been trading for a considerable amount of time need to also reevaluate their trading conditions to see if they are getting the best deal possible.
Brokerage fees, trading commissions, call it whatever you want. They exist because of the service that is provided by the brokerage.
When you buy or sell a product from a vendor, you will no doubt pay some commissions on the original price. In the world of financial investments such as stocks, bonds, futures, commissions play an important role and are unavoidable at any cost.
When you transact with your broker, you pay a fee to the broker for giving you this service. There is no way to avoid this, unless you get a seat directly at the trading pit, which is usually out of reach for the average retail investor.
Trading commissions can play a big role in determining your profit and loss. They can reduce your profits, and they can also increase your losses. The inclusion of trading fees is important as it impacts your profit and loss statement which has its own tax ramifications.
Trading fees are usually included into your trading as part of the total cost of the transaction. This is true not just when you trade a financial product but in almost every day purchases. Trading fees, depending on the jurisdiction and the local tax laws can be excluded from the final tax that one might have to pay.
For the average retail trader, understanding the trading costs upfront can be very beneficial not just in their trading but also in terms of the resulting taxes on the profits as well as in managing their trading capital.
Why do brokerages have different trading commissions?
One thing that traders might notice is that the trading fees or commissions vary from one brokerage to another. You will also find that the trading fee differs from one financial product to another. These differences in the trading fees of course contribute to the broader confusion, especially among new traders.
Different brokerages have different trading fees or commissions for a number of reasons.
For starters, brokerages that offer low commissions are the ones that enjoy a higher volume of transactions. Typically in the retail trading business, brokerages can enjoy lower transaction fees when they generate higher volume of business for the exchange.
You can also expect to see lower trading fees for brokerage whose only job is to execute or relay your orders to the main market. The moment the brokerage brings in additional services, you can expect to see the trading commissions and fees start to grow accordingly.
Secondly, the online brokerages don't just charge a trading commission fee, but also other hidden fees. These can be account maintenance fee, account inactivity fees, transaction fees on deposits and withdrawals and so on.
Different types of retail trading brokerages
The trading fee or commissions charged by a broker, depends on the type of business and the services that is provided.
Most of the online retail brokerage firms can be classified into one of the three categories.
Full service brokerage: A full service broker firm sits on the top of the ladder. These are firms that offer complete investment or managed funds services. Such brokerage firms tend to have full-fledged team of researchers and offer value added services such as giving trade recommendation to the clients as well as managing money for high net worth individuals.
Needless to say, such full service brokerage firms charge huge fees. Due to the nature of the clientele, the full service brokerage firms have a higher level of entry requirements to open an account with them.
On top of this restriction, these firms charge additional fees such as annual fees and levy a percentage of the transactions as trading commissions.
Online brokerage: The online brokerage service sits in the middle and is often seen as offering a mix of services that clients can pick and choose. Investors who are savvy about the markets can use an online brokerage firm only to relay their orders, while some might opt for even choosing for a full service type of recommendation.
An online brokerage firm typically manages their services and business completely via the Internet. Of course the brokerage firms need to be regulated no doubt but offers a better value for money on the service that is provided.
An online brokerage usually has additional fees such as account maintenance fees and so on on top of the transaction fees made per trade.
Discount brokerage: A discount brokerage firm is the cheapest of the three and is most affordable for retail traders. Although despite being advertised as cheap, traders should read the fine print.
Many discount brokerage firms will advertise the cheap transaction fees provided that the trader meets a monthly trading volume. The discount brokerage firms do not offer any other additional benefits and is purely for trading purposes only.
In most cases, the discount brokerage also does not charge any maintenance fee or other costs, but again this is dependent on the trading volumes. While it might seem cheaper, traders should opt for this only when they know that they can match the required trading volumes.
Such type of brokerages are ideal for day traders as they can trade in higher volumes, compared to traditional buy and hold investors whose trading volumes are comparatively lower.
What are the types of trading commissions and fees you can expect
A brokerage firm will typically have two types of fees that they will charge; trading fees and non-trading fees.
Types of trading fees (Fixed, percentage, tiered)
Trading fees, as the name suggests are associated with the trading aspect of the business. Here, the charges applied are of three types.
Fixed or flat fee: A fixed or flat fee charges you a flat rate every time you trade, be it trading just 1 share or 100 shares of the same stock. Under the fixed fee structure, you will have to pay for both buying and selling (opening the trade and closing the trade). So, if you see a fixed fee of $4.95, this means that you pay $4.95 for buying and you will pay $4.95 when you sell or close that trade.
Floating or percentage fee: Under this scheme, the brokerage will charge a percentage of the trading volume as commissions. This is typically applied to high end brokers. A typical floating fee would be in the form of the brokerage charging 0.5% on the value of the trade.
For example, if you bought 100 shares for a stock that is trading at $10, your value of the trade is $1000 (100 shares x $10). Thus, the brokerage’s trading fee at 0.5% will be $5.
From the above two examples you can see that the fees between the two types are nearly the same. But when you scale up your trading activity you can find a big difference.
Let’s take an example where a trader makes 5 trades during a month.
In the above table you can see that the flat fee amounts to a total of $49.6 for all the transactions. On the other hand, the percentage based fee is significantly higher at $2,272.5. So at the first glance, one can see that the flat or fixed rate is better.
But look at row 2. Here, when a trade is made for just one share at $5, the flat fee comes to a total of $9.90. On the other hand, the percentage based fee charges just $2.50.
Tiered fee: A tiered fee is charged based on the number of trades a trade makes. Usually, under this model, the more number of trades a trade makes, the lower their costs become. For example, you might be charged $4.95 on the first 100 trades, $4.50 on the next 100 and so on.
Depending on the broker in question, the tiered rate is applied or adjusted on a monthly basis. In this scheme, traders can expect to see lower fee applied on all the trades. Contrary to the above example, if your monthly volume was 200, then you would be applied a total tiered fee of $4.50 on the all the 200 trades instead of being charged $4.95 on the first 100 and then $4.50 on the next 100.
Among the above, the tiered commission is probably the best choice for day traders who prefer to trade in the short term. On the other hand, traders with a buy and hold type of approach and who have a lower number of transactions will of course find the flat fee a better option.
Non trading fees include a number of charges and these fees basically depend on the broker. Some of the commonly applied non-trading fees include:
- Account maintenance fee: This is usually charged once per quarter or a year
- Account inactivity fee: These fees are charged when your account is dormant over a specified period of time
- Data feed/Charting platform fee: If you opt for pricing data feed from the broker or a charting platform, you will be charged a fee on these services
- Miscellaneous fees: Other miscellaneous fees include phone brokerage services, account statement requests and so on.
Understanding trading commissions
Understanding the costs associated with trading is no rocket science and traders who spend some time browsing through the brokerage’s website can quickly understand the full costs involved. Below are some key points that traders should bear in mind.
Trading commissions changes from one product to another
Do not expect uniform pricing. Trading fees changes depending on what you are trading. For example, a broker might charge you a flat rate of $4.95. This means that whether you buy 10 shares or 100, you pay a flat rate of $4.95 when you buy (and pay $4.95 when you sell those shares).
Example: You bought 100 shares in AAPL, at a rate of $100. Your transaction cost will be $4.95.
Your total cost will be 100 shares x $100 = $10,000 + $4.95
You now sell the 100 shares at $110. Your total profit will be 100 shares x $110 = $11,000 + $4.95
After deducting the fees ($9.90), your net profit will be $11,000 – $10,000 + $4.95 + $4.95 = $990.10
On the other hand, if you were trading options, you would be charged on average a few cents + a base rate. And finally for futures trading, the fees will be a fixed flat fee for 1 contract.
Example: The trading fee is $5/contract for trading the ES futures. So, when you buy 2 contracts, your fee increases to $10.
Trading fees change not just from futures to stocks or options, but also within the market itself. For example, you will get two different pricings when you trade stocks above $10 and below $10. Likewise, in futures trading you will get different trading commissions when you trade index futures and different fees when you trade commodity futures.
Role of Fintech in lowering trading fees
With the advent of various Fintech firms, the trading landscape has become even more competitive. Firms such as equities.com for example have begun to offer a flat monthly fee of $29.95, with no commissions and no hidden fees.
Other examples include, Motif Investing which offers a flat rate of $9.95 to trade up to 30 stocks or even a monthly subscription based service that eliminates any fees or commissions on the trade.
Robinhood, which is another Fintech firm, charges absolutely no fees when you trade U.S. equities. With more and more such Fintech firms coming up, there is a very high likelihood that retail traders will soon be able to see lower if not no costs to trading in the near future.
In conclusion, trading costs are an important aspect of trading that retail traders need to focus on as it affects not just the capital that they trade with but also the bottom line profit or loss and the resulting taxes on the profits one makes.
In order to find out the best costs, traders need to focus on factors such as the number of trades they make per month and the type of markets that they trade which can then enable them to choose the right brokerage that offers traders the best conditions for trading fees.