What are the hidden costs of trading?
As competition for client accounts heats up among the major online brokers, we have seen a price war emerge which results in a lower and lower price per equity trade. Some new brokerage firms even offer free equity trading or “all you can eat” monthly pricing.
While at face value this may seem like good news, it is a great time to remind active traders and investors that there are often other hidden costs of trading associated with investing and some of them can be very impactful.
For example, does your online broker shop your transaction flow? If they do, they are making money on your trades by selling the flow of orders to a trading firm that will match the transactions without going out to an exchange. In principle, this sounds like a great idea, but experience shows that many times, investors may not be getting the best execution.
So what are these hidden costs of trading?
2. Execution quality
3. Bid/Ask spread
Let’s look at these hidden costs individually.
Taxes can be one of the big hidden costs of trading.
Assume that you have entered into a profitable trade/investment and you decide you want to take your profits. If you take your profit in less than a year you will end up having to pay taxes – at your ordinary income tax rate (~28% for most of us). If you held the stock for more than one year the tax rate is reduced to 15% (for most of us).
When you consider taking profits, consider how long you have held the position. Finally, a great way to reduce the impact of long-term capital gains is to offset gains with losses.
Poor execution is the hobgoblin of transaction costs. Fortunately, execution quality has improved greatly over the past decade.
Alternative Trading Systems (ATSs), Electronic Communications Networks (ECNs), and other sources of liquidity means that your transaction will be executed in a fraction of a second. Sometimes you may receive a slightly better price than you “see” on your screen. But was that the best possible price you could have received? Could you have gotten a slightly better price, say a tenth of a cent better? A fraction of a penny sounds like a small amount, right? However, if you are trading 10,000 shares and your broker misses out on a tenth of a penny, this just added $10 to your overall cost.
To learn more about this phenomenon, check out this article from Stockbrokers.com.
Finally the bid/ask spread. This issues is magnified in illiquid stocks or options. Simply put, if you put in a market order, the exchange will match your order to the nearest bid or ask. This usually has a very minimal effect, but if there is no liquidity in a security, this can have a bigger effect.
So, yes, broker costs have come down significantly in the past couple of months, but these hidden costs of trading are still out there.
If you are trading frequently, or in illiquid securities, it is worth understanding your broker’s policies, and how these will impact your overall profit.