Cost of Trading Stock

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 of the overhead of trading is the cost of commissions, there are other more significant costs that can outweigh low commissions.

Bid/Ask Spread

The bid and ask spread is the difference between the price quoted to buyers of a security and the price quoted to sellers. In this historical example, a trade of 1,000 shares of a stock with a bid of 19.90 and an ask of 20 uses a commission fee of $14.95 at a discount broker and costs 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 the historical Securities and Exchange Commission fee used in the example, .00307% of the principal amount of the sale, and the round-trip trading cost reaches $130.51. So much for low commissions. SEC fees are another cost to include in the round-trip transaction.

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 percentage 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 at 80 cents with a 5-cent 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, 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, they are only good for a 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 stock and 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 between placing an order and getting it executed. The way your order is routed is 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 multiple 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.

Margin Rates

The overhead of trading can be substantial. What is the cost of doing nothing? The interest collected on cash sitting in a brokerage account is credit interest. The rate for credit interest paid by most brokers is a pathetically low, often a fraction of a percent. The margin rate, the interest rate charged for money borrowed from your broker to trade share amounts above your account value, is often one-half of a percentage point higher than the broker's call rate. The historical example in this article cites a broker's call rate of 4.25%. Margin interest charges can be 20 times the rate of credit interest. Most brokers have a method to sweep cash balances into a money market or similar fund that bears a rate of interest comparable to a CD (certificate of deposit) or short-term Treasury bill, but you have to ask for it. Commission, fee, interest, and regulatory-rate examples in this article are historical illustrations, not current pricing or financial advice; verify applicable terms and rates before trading.