Understanding trading costs and the truth of how they can kill the performance of any strategy.
All trades incur costs. These costs will dictate your expense ratio depending on the amount invested. If all trades cost $10 to execute and an average alert involves several opening and one closing event, the total cost to complete the trade could be $50. If you do not have access to advanced algorithms (more on this later), you will have more transactions to achieve “average” pricing. This could double trade costs to $100.
With $10,000 invested, that represents 1% of the investment. That’s too much. If the cost is $5 per share, that is 0.5% of the investment. This is better. If the cost is $1 per share, the cost is just .01% of the investment. If you are investing more, the relative cost per share as a percentage of the investment becomes more affordable assuming the cost is fixed.
Of course investment costs can be even higher. There are regular Brokers that employ salespeople who charge in excess of $50 to $75 per trade. For this strategy, these should be avoided.
Due to the trading activity, Summerland Alerts rely on discount brokerages that allow you to place trades directly through their trading platforms, bypassing the salespeople and saving commission costs.
But there’s a catch that no one talks about. So-called discount brokerage firms may in fact create opportunity costs. There is a hard cost of executing trades within the marketplace that is an unavoidable cost and at present it is around $0.0045 per share traded.
This hard cost is difficult to understand when discount brokers offer such deals as trading 5000 shares of stock for $9.95. Think about it: such a “deal” would equate to a trading cost of $0.00199 per share. That is significantly lower than the “real” market cost. Again, there is no escaping this physical cost to the broker. So, how does a discount broker that offers the $9.95 trade make money?
It’s really quite simple. They sell the trades to a third party for a profit. That third party then uses many techniques that help them make a further profit on the trade.
Let’s examine how this process works for Scottrade a leading discount broker. In their case, 40% to 56% of their trades are “sold” to a company called KCG Holdings (Formerly Knight Capital Group).
KCG pays the discount broker an amount per share to receive the orders, perhaps .002 per share. So that discount broker makes $10 on that 5,000 share trade beyond the $9.95 they charge you, their client.
In turn, KCG places the order into the market taking advantage of market inefficiencies and trading timing. KCG’s cost to acquire these shares (.0020 paid to the discount broker) and to execute the trade (.0045) is now around .0065 for 5,000 shares or about $33. KCG then uses its trading methodology and technologies to find hidden cost “advantages” in the market.
For example, leveraging just .01 per share cost difference would net Knight a $50 gross return or a profit of about $18 on those 5,000 shares. Multiply these relatively small trades by a huge volume and the profits are immense.
Who pays?
You do as an investor since these trade costs get built into your cost for the transaction spread across all the shares you buy or sell.
That $9.95 trade of 5,000 shares at Scottrade actually costs:
$9.95 for the initial trade +
$10 in”hidden” profit that discount broker makes off selling the “trade” to a third party +
$18 of “hidden” profit that KCG finds.
In total, the trade actually “cost” $38 to execute not $9.95. That’s $9.95 for the trade plus probably around $0.0056 per share spread over 5000 shares. You don’t see this “hidden” cost because it is simply burred in the price you pay for the equity.
When you examine the profit being made by the various parties involved the real trading cost is significantly higher than if you removed these middlemen.
On the smaller trade size, the “discount” brokers still come out ahead.
Let’s say $10,000 is invested in SPY.
At $165.86 per share and using margin, one could purchase 120 shares.
At $9.95 for that transaction, that’s $0.083 per share in commissions.
Minus the hard cost of $0.0045 per share, the discount broker makes $0.078 per share… roughly $9.36 after the trade cost is included.
In fact most wealthy investors work through a Prime Broker, such as Goldman Sachs, to pay a flat cost per share to execute trades. Typically this starts at around $0.015 per share and can go lower than $0.01 as the amount being invested climbs. If one is investing $1MM or more, one will pay at or less than one cent per share.
The advantage to this is that there are no middlemen and as such, if there’s any “slack” in the market, you receive the benefit directly instead of it going to the “discount” broker or someone like KCG.
There are some brokerage firms that offer the advantage of “per share” pricing to investors even if they aren’t multimillionaires.
Interactive Brokers offer “per share” pricing that leverages sophisticated systems to help you get the best pricing while cutting out the middlemen. Interactive Brokers offers trades for a minimum of $1.00 plus ancillary costs. They are truly one of the best priced firms around but have a $10,000 minimum opening balance.
ThinkorSwim is a part of TD Ameritrade. ThinkorSwim offers flat “per share” pricing with a minimum cost of $5 per trade and best price routing. For larger accounts of $250,000 and above, they offer the ThinkPipes platform which also gives access to very sophisticated algorithms. Interactive Brokers offers better pricing than ThinkorSwim for smaller investors.
FolioInvesting doesn’t offer per share commissions and likely engages “middlemen” in taking shares to market, but it takes a novel approach to pricing that makes it worth considering for investors with less than $10,000. They provide the investor with access to frequent trading while limiting the cost to one flat fee per month. For investors with less starting capital, this is the best solution as the investor can take advantage of the Summerland Alerts while keeping the overall cost per share to a minimum. They do not allow margin, so if you have more than $10,000 we strongly advocate considering Interactive Brokers instead. While they do not offer sophisticated algorithms for trading, they do offer two trade “windows” that allow one to capture an approximation to the average of the market by placing trade orders in these two daily trade windows.
The important thing to realize is that there’s really no “free lunch”. There are set-in-stone execution costs that are inescapable and using so-called “discount” brokerages may not be the bargain they appear to be.
As an investor managing your own portfolio you need to be sure you maximize every dollar invested . One key way you can do this is by using the right online brokerage who will eliminate the middlemen and pass the profits on to you.
Coming Up Next
Back | Course 9: Never underperform the average price of the market with these techniques.
