Saturday, November 07, 2009

Costs of Trading

Last weekend I wrote an article about trader education and how important I considered it to be. Obviously, as with any education, there are costs to be incurred. As I noted in "Smart Investors Money Machine" education is becoming increasingly expensive. One kindergarten I checked out, for example, charges $3,500 a semester. Coaching and trading seminars can certainly rival the cost of kindergarten, but rather than playing with paste and crayons, the would-be trader may be readying herself to risk tens to hundreds of thousands, or even millions. Any education has a cost whether it be in books, DVDs, instructors time and facility costs, or whether it be through self-learning by putting money at risk without really knowing what one is doing in the markets. As I often tell students, trading can be simple, but it definitely isn't easy.

In response to the article last week, I received a request from a reader to discuss other costs of trading beyond those directly resulting from paying for education. One of the first and most obvious costs are commissions. If one is an active trader or a trader who is trading a relatively small account, commissions can become a very important consideration. Suppose a trader is paying $10 in commissions to enter a 100 share stock position when the shares of stock are trading at $5 a share and that he sells those shares after the stock has a $1 a share profit. He now pays another $10 commission to exit the trade. Before commission, he has a $100 profit, but that profit is reduced to $80 by commissions. He has lost 20% of his potential profit just through commissions. To view it another way, the same $5 stock must move up 4% just to break even in this small trade example. While a $10 commission sounds small (and it is compared to what commissions used to be) they can be a very important factor to someone who is making fairly small trades.

Very active traders like me may make literally hundreds of trades in a year. Suppose I make 500 (250 entries and 250 exits) option trades in a year and pay a commission of $12.50 to enter a 10 contract position and another $12.50 to exit the position. Over the course of the year, I would have $6,250 in commissions. On a $100,000 account, I would need to make at least 6.25% profit just to break even. When we think what CDs are paying, we can see that commissions can be an important consideration in our trades.

Many investors buy open end mutual funds and may face large charges from the fund company. For example, when researching for my book, "Trade Your Way to Wealth," I found one mutual bond fund that charged 13.5% as an "investment advisor fee" on income and added another 1% as a "custodian fee." Unless an investor reads the Prospectus and understands what he is reading, he may have no idea of the exorbitant costs of investing in some mutual funds.

Yet another cost often found in trading is the spread. Option traders are familiar with this cost. Any option is quoted with a "bid" price and an "ask" price. The "ask" is the price at which someone (usually the market maker) is willing to sell and the "bid" is what someone (usually the same market maker) is willing to pay. If we saw an option quoted at $1.00 x $1.25, it would tell us we could buy the option at $1.25 a share (option contracts usually are for 100 shares per contract) and that we could sell the option for $1. Suppose we bought 10 contracts at $1.25 (that's 100 shares x 10 contracts = 1,000 shares x $1.25 per share) for a total of $1,250 and for some reason, we had to sell immediately. We would sell at the $1.00 bid and get $1,000 and would have lost the spread or, in our example, lost $250 just as a result of the spread. Wise option traders will know that they might be able to get "in between" that spread so the loss from the spread might not be quite so dramatic, but there would be some loss even then because getting "in between" the spread only means some savings, not that there is no spread.

Yet another similar issue is known as slippage. Slippage often occurs when the investor or trader places market orders. Suppose we see that a stock is trading at $25 a share and we place a market order to buy 200 shares at the market. By the time our order gets executed, the price might be $25.30. That is the price we wind up paying so instead of making a $5,000 plus commission investment as we thought we might, we have paid $5,060 plus commission. One way to avoid the slippage on entry is to place a limit order. If we placed a buy limit order of $25 a share, we know we would not pay more than $25 a share plus commission, but we might not get the stock; the price might have gone up and we missed the trade. The market order to buy would have assured us that we would buy the shares, but we really don't know at what price. Suppose the stock was trading at $25 as we placed the order, but before our order got to the floor trading was halted for some news announcement and the announcement turned out to be very positive sounding and the stock then re-opened at $50 a share. Now our market order would be filled at $50 instead of where we were thinking. Then suppose there was a subsequent announcement that clarified the earlier announcement and made it clear that it was not as positive as earlier presumed. Then the stock fell back to $25. Now, because of our market order, we bought at $50 and shortly thereafter owned that same stock trading back down at $25. While that may be an extreme example of slippage, things like that have happened and do happen.

Hopefully, readers will recognize that there are many potential costs attendant to trading and one of the best ways to ultimately reduce them is to be aware and pay for the education necessary to learn how to control them.

by Bill Kraft, Editor
Copyright 2009, Makin' Hay, Inc.
All Rights Reserved

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Anonymous said...

Very important information, especially regarding slippage.

Also if you are trading a self-directed account as an IRA, the commissions are higher and you cannot trade options or short the box to protect. Your limited to buy and sell only.

Bill Kraft, said...

Thanks for writing, Anonymous. I should note, however, that options can be traded in IRAs and commissions are dependent upon the brokerage. One can even trade naked puts in IRAs if permitted by the brokerage and some brokerages do permit such trades. You might want to check out some other brokers.
Bill Kraft

Anonymous said...

Greetings, I really enjoy your articles and of course have both of your books. Something that I would love to see you cover in a future article....scheduling your time. How much time to you devote to screening for new trades, increasing knowledge of chart reading actual trading etc etc. With the possability of layoffs in the future I would like to graduate to trading full time.

Bill Kraft, said...

Thanks for writing, Anonymous. I'll certainly consider an article on scheduling time although that is a very personal issue and may well be unique to the individual. You might want to review the section on the business plan in "Trade Your Way to Wealth" to get some ideas of what might work for you. In "Smart Investors Money Machine" I discuss various strategies for producing regular income and include information on how folks at different times of their lives and with differing needs might choose strategies that fit their personal circumstances. Thanks, too, for buying my books. I hope they have been helpful.
Bill Kraft

Alex B. said...

I want to Thank You for your weekly emails.I am a single male in my early 50's have found comfort in dollar cost averaging in DRIPS.I have been swing trading this year but took a loss lately that has left me paralyzed to take on another trade.I have read one of your articles a few months back about someone you were coaching with a similar issue and you told him to trade a smaller amount of shares.He was still unable to execute a trade in that it affected him emotionally.I feel the same way.Is there any suggestion that would help me? Thanks Again