Commissions
Most brokers try to win new customers with the allure of low commissions, free trades, free electronics, or a bevy of other incentives. Although a significant part the overhead of trading is the cost of commissions, there other more significant costs that outweigh low commissions.Bid/Ask Spread
The bid and ask spread is the difference between the the price being quoted for buyers of a security and the price being quoted sellers. A trade of 1000 shares of a stock with a bid of 19.90 and an ask of 20 will incur a typical commission fee of $14.95 at your discount broker and cost 20,014.95 to execute. But turn around and try to sell that stock right away, and you'll only get the bid price of 19.90. Add another commission to sell the stock and a Securities an Exchange Commission fee of .00307% on the principal amount of the sale, and the cost to trade in and out of the stock just jumped to $130.51. So much for low commissions.
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Consider the bid and ask spread as a percentage of the transaction. If a $20 stock has a spread of 10 cents, the cost of the spread will reduce the return on the trade by 0.05%. For higher priced stocks, the overhead as a precentage of the trade is reduced. A stock trading at $100 with a .10 bid/ask spread has a 0.1% overhead from the bid and ask spread. Not too bad. Now consider penny stocks. A stock trading a 80 cents with a 5 cents spread has an overhead of 6.25% from the bid/ask spread alone. Consider trading $10,000 of such a stock, the bid/ask spread will set you back $625! That's if $10,000 worth of the stock is available at the current ask price.
Poor Liquidity
When the bid and ask prices are quoted in the market, the are only good for certain number of shares. The number of shares being offered at the quoted bid or ask price is known as the size or depth of the market. When placing a market order for a number of shares that is larger than the size of the bid or ask, some of the order may be filled at a worse price than was quoted. These partial executions are common for large orders, penny stocks, and lightly traded stocks option contracts.When trading large quantities of stocks, particularly penny stocks, don't rely on the bid and ask quotes you get from your online broker, pick up the phone and ask your broker to get a better price.
Order Delays
When the order finally reaches the market, it may not be getting executed in a timely fashion. Orders that don't reach the market immediately are subject to price swings, which can add to or reduce the cost of the transaction. Stock and option orders are not executed by your broker, they are forwarded to either an ECN or directly to an exchange. This routing can add to the delay betweeen placing an order and getting it executed. The way your order is routed determined by what best benefits your broker. Brokers often get paid for routing order flow to ECNs. ECNs determine how to execute orders using proprietary algorithms that analyze quotes from different sources and route the destination that offers the best bid or ask. If mutltiple sources will honor the best bid and ask, the ECN will route to the destination that benefits them. These decisions are made electronically, but orders will queue up waiting to be acted upon, and these delays may result in a poor execution price.
Liquidity
The bid and ask spread is wider for lightly traded securities and tighter for active issues. In general, the more volume in a security the better the pricing, and the more likely your order will get executed quickly. Try to avoid trading in a market where the floor broker has to mull over whether to fill your order. A market with a lot of active buyers and sellers enables traders to liquidate their positions quickly, and often results in lower spreads and faster executions. This is particularly true in the options market, since the bid and ask spread are subject to change without any trading activity at all.