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The hidden costs of trading stocks

A lot of brokerage companies advertise commissions for trades for $10, $5, free, etc.  What they don’t tell you are all the hidden transaction costs.

The short and simple story

  1. For the biggest companies that can be traded the bid-ask spread is usually one penny.  If the bid-ask spread is a penny, your hidden transaction costs are somewhere around 29 to 50 cents per 100 shares.  So suppose you are buying 2000 shares of a major company like Microsoft.  Your brokerage’s commission is $10.  Assume that the hidden transaction cost is 29 cents per 100 shares.  So the hidden transaction costs are 29 cents/100shares * 2000 shares = $5.80.  Your total transaction costs are $15.80.  If you buy 100,000 shares of a stock with a very low share price, then your total transaction costs would be $300.
  2. If the bid-ask spread is more than a penny, your hidden transaction costs may be a lot higher.
  3. The hidden transaction costs on all-or-none orders and market orders can be extremely high.  This is a shady area where those in the financial community can make a lot of money.  Bernie Madoff used to run a market making firm that generated a lot of profit from market orders from retail customers (and these profits were considered legal).  Instead of using market orders, use a limit order at 0 to several cents past the bid/ask price.  In other words, buy at a few cents above the ask price.  Your order should execute right away, but your broker cannot gouge you for more than your limit price.
  4. For stocks that trade infrequently, you may be charged multiple commissions.

The long story

Here’s how the system works. For every stock, there is a bid price and an ask price.  Suppose the bid price is $3.00 and the ask price $3.01.  If you want to buy shares right away, you have to pay $3.01/share.  If you want to sell shares right away, you have to pay $3.00.  In theory, you can post an order at the bid price of $3.00 and wait for somebody to sell shares to you.  So, you would pay $3.00 instead of $3.01.

Your order may be routed onto an ECN (electronic clearing network), which is a computerized system where parties trade stocks with each other.  Suppose you are trying to buy 100 shares of Citigroup at $3.00.  Suppose your broker routes your order to the NASDAQ/Instinet ECN (electronic clearing network).

The various ECNs have a rebate fee structure.  For somebody to sell 100 shares to you, they have to pay $300 plus an ECN rebate.  The ECN rebate for NASDAQ is 29 cents per 100 shares.  Somebody selling to you receives $300 minus 29 cents, which is effectively $299.71.  You are paying $300 for something that somebody else is selling for $299.71.  You do not get to collect the difference as most retail brokers keep it for themselves.  Of the 29 cents, the broker is probably getting 28 cents and the exchange 1 cent.  Some brokers such as Interactive Brokers pass on these ECN rebates.  But, generally speaking, retail brokers do not pass on these ECN rebates.  So, you are usually paying at least 29 cents per 100 shares for each trade.

It gets a little worse.

The various exchanges and ECNs generate most of their money from “market makers” and/or “liquidity providers”.  Or in the case of the Directedge exchange, the exchange is owned by various market making companies (Goldman Sachs, Knight Capital Group, Citadel Derivatives Group) despite the conflicts of interest.  In return, market makers get special advantages over other market participants (why else would anybody pay exchanges lots of money?).  One of these advantages is the ability to step in front of orders at the last second and to fill it with a minor price improvement.

The website “Trading Defenders” provides a very in-depth and technical discussion on the practices of price improvement, sub-penny pricing, and broker-dealer internalization.

Price improvement

Imagine you were buying an item on eBay and you had the best bid at $300.  At the last second, somebody else steps in and bids $300.01.  The other guy wins the auction… by one penny.  You would probably be angry.  For this reason, eBay has rules against such behaviour.  You have to top other bids by a lot more than 1 penny.  Unfortunately, stock markets do not have such rules.  This is a source of profit for the market makers.

Suppose there were retail orders to buy at an effective price of $299.71 and to sell at an effective price of $301.29.  The market makers will constantly buy at slightly above $299.71 and constantly sell at slightly below $301.29.  If you are trying to buy 100 Citigroup shares at $299.71, your order may not fill for several hours even though Citigroup is usually the most frequently traded stock on all the exchanges.  If you do get filled, it is usually because the stock price is moving against you.  The market makers will sell their inventory to you and leave you holding the bag.  Some people refer to this practice as front running.  In theory there may be regulations that make such practices illegal or unethical.  Regardless, it occurs in practice.

One way you could avoid front running is to buy at the ask price and sell at the bid price.  Buy at $301.00 and sell at $300.00.  This would cost 50 cents per 100 shares (the difference is $1 spread over 2 orders, so $1 / 2 is 50 cents).  You might ask… why would the brokerage execute your order to buy at $301.00 when it could cost them $301.29 to buy your shares on NASDAQ/Instinet and they would have a 29 cent loss?  It is usually the case that you can buy shares right away at $300.98 (if not less) and sell shares at $300.02 (if not more).  There is a lot of competition between buyers and sellers.  So the broker is able to buy shares right away at $300.98, charge you $301.00, and pocket the 2 cents.  Usually there are companies that offer better pricing than what is displayed in public markets (this is broker-dealer internalization), so the broker can pocket much more than 2 cents on these types of trades.  In certain cases it can go up to 14 to 50 cents.

Multiple commissions

For stocks that don’t trade very often (e.g. very small companies such as those under 100 million in market capitalization), your order may be spread across multiple days.  Your broker may charge you a commission for every day that it takes for the order to execute.  If the order takes 3 days to execute and the commission is $10, then you will pay $30 in commissions.  They may also break orders into smaller chunks, increasing the likelihood that the order will take multiple days to finish executing.

All or none (AON) orders

You might think that an all or none order would protect you against multiple commissions.  While that may be true, the cure is probably worse than the disease.  AON orders are held on a special order book.  Suppose you place an AON order to buy 20000 shares of a stock at $6, and the bid/ask for the stock moves down to $5.00/$5.01.  Your order does not execute unless there are 20000 shares on the order book between $5.01 and $6.  So a market maker will try to accumulate 20000 shares at $5.00/$5.01, and sell those shares to you at $6.  (This is an extreme and unrealistic example but illustrates what can happen.)

It is probably for this reason that AON orders have been banned in Canada.  You may wish to avoid them.

Market Orders

Market orders can give financial companies a license to steal.  The following article describes one method that Knight Capital Group makes profits from unsuspecting retail investors: “Role as Big Nasdaq Market Maker Helps Knight/Trimark’s Portfolio“.  Note that the profitability of this strategy is much lower as retail investors are no longer speculating in the market as much.  There are other mechanisms where market makers and other companies can make surprising profits from market orders.

A simple alternative is to use limit orders.

Stop Orders

Most stop orders are usually a market order by default.  So they have the same problems as market orders.  You could potentially use limit stop orders, although this may be risky as the limit order is not guaranteed to execute.  It is possible for there to be large discontinuous jumps in stock prices, especially overnight.

Another problem with stop orders is that market makers and traders may try to manipulate the market to intentionally trigger them.  They can profit from the forced buying and selling that occurs.  They may know the exact price that triggers these stop orders.  Or they may simply be skilled in guessing, as human beings tend to have patterns in placing stop orders.

Closing remarks

These are some of the most common ways in which trading costs are higher than what you might expect.  Unfortunately, most of the financial community is not interested in making the system transparent and fair as their business models revolve around exploiting the ignorance of their customers.  On the other hand, the abuses are much lower than what they have been historically.  Compared to the past, transaction costs are much lower.

When choosing an online broker, keep in mind that not all brokers are the same.  Some brokers engage in more shenanigans than others.  Unfortunately, it can sometimes be difficult to figure out the exact transaction costs because it is difficult to calculate.  Also, brokers typically do not release useful statistics on the quality of their execution.

As the financial landscape is constantly changing, the information you read here could be outdated.  Transaction costs may decrease or increase in the future.