How Trading Commissions Can Kill Profits
When it comes to trading financial instruments like stocks, options and futures, traders and investors have to part with commissions. As an unavoidable cost, it has an impact on the profits earned by traders and investors. Today, it’s quite difficult to trade without connecting to a brokerage firm. To ensure service provision, brokerage firms have to charge fees when it comes to the buying and selling of financial instruments.
Let’s face it. It is quite difficult for traders and investors to have the front row seat at the trading pit. Today, computer systems controlled by sophisticated applications with AI capabilities allow traders and investors to have access to real time market data. As a result, traders are able to analyze different symbols and indicators thus profiting from the market from the comfort of their home.
What you need to know is that trading commissions are a large part of trading so knowing how they work will help you understand how to keep them at a minimum. Below we will go over the different types of commission structures offered by most brokers.
Types of trading fees
There are three main types of trading commissions and they include:
- Fixed Commission
- Floating Commission
- Tiered Commission
Let’s take an in-depth look at the above trading commissions.
Also referred to as a flat fee, this is a fixed rate that is deducted during trading whether a trader has traded a single share or they have traded a large amount of shares. When it comes to a flat fee, traders and investors are required to pay for both buying and selling trading sessions.
For example, if the flat fee is $3.65, then when you purchase a financial instrument regardless of the quantity, the brokerage firm will deduct $3.65. This is the same when selling financial instruments.
Also referred to as a percentage fee, the brokerage firm will charge a particular percentage of the trading volume as a commission. What you ought to know is that floating fees usually apply to higher end brokers. Normally, brokerage firms charge 0.5% for example if trader A purchases 200 shares of stock X currently trading at $7, then trade value will be
(200 shares X $7) =$1,400
The floating fee charged by the brokerage firm will be:
(0.5% X $1,400) = $7
While both fixed and floating fees examples above seem to be similar, when calculated over a certain period of time, the flat fee will be much less for both buying and selling sessions when compared to the percentage fee.
While this may seem advantageous at first, if the trading volume was less, then the flat fee will be much higher than the percentage fee.
Tiered commissions are usually charged by brokerage firms based on the number of trades completed by a trader. In this form of fee structure, the trader will experience lower costs if he or she completes more trades. Let’s assume a trader is being charged $3.65 for every 50 trades completed. For the next 50 trades completed by a trader, the brokerage firm may charge $3.50.
You may be wondering how this happens. Well, brokerage firms usually adjust the commission on a monthly basis which means if you were to purchase 100 shares, you will incur $3.65 and not $3.65 for the first 50 trades and $3.50 for the next 50 trades.
Due to this, the tiered fee structure is the best for day traders who prefer to trade on short term and make a lot of trades.
How Trading Commissions Affect Profitability
As said earlier, it is quite easy for traders and investors to overlook how trading fees affect their profitability over the long run. This is true especially for active traders who trade a lot and pay a ton in commissions each year.
If you were to calculate the amount of trading fees charged over a long period of time, you will be surprised by the amount of money charged. Regardless of this, traders must pay the trading commissions if they want to continue enjoying brokerage services.
So, how do you enjoy more profits while incurring lesser trading fees?
One of the best ways to reduce commissions is to trade less. Over trading will rack up commissions and drastically reduce your profitability. Remember, trade the best and leave the rest!
Another way to reduce commissions is to study your trading style and look for brokers that cater to that style of trading. For instance, if you scale in and out of trades then perhaps a per share commission structure will work best for you. Or if you trade large size then look for brokers who offer tiered commission rates which will reduce your commissions once you trade a certain amount each month.
As a trader or investor, you need to be prepared to incur trading commissions when trading. To ensure that you are able to enjoy a higher level of profitability at all times, research on low cost broker firms and which commission structure best fits your trading style.