The advent of online trading has made a huge difference to the commissions being charged to execute a trade. Before the Internet, the only way for a trader to buy or sell trading assets was to ask a broker to execute the trade on his or her behalf. This usually happened over the phone.
Understandably the broker had to charge a fee for the time it took to communicate with the customer and then execute the trade. It also has to be said that the services of the broker usually went beyond merely taking and executing orders. There was usually a fair amount of consultation involved.
Broker assisted trading is still available and for beginner traders and investors it might be the perfect way to get started. Paying for the advice of someone who knows the market through years of experience could be well worth the price.
For traders choosing the online route of self-trading however, it is important to watch the costs. These usually consist of two elements: direct commissions and the spread.
With stock options trading the general rule is that the trader would charge a fixed fee per transaction and an additional fee per contract. Since this article is not about recommending specific brokers an explanation of how different commission structures could affect the profitability of a trade might be helpful.
Smaller traders in particular should try to find a broker with a lower fixed transaction fee. For a trade consisting of only 2 contracts, paying $20 per transaction boils down to $10 per contract – which could well turn a marginal trade into a losing one.
Traders who trade in larger volumes would be wise to compare ‘per contract’ fees of different brokers. In this case it’s of no use paying a small fixed transaction fee and a high per contract fee.
Broker A charges a fixed transaction fee of $10 per trade plus $2 per contract. Broker B charges a fixed transaction fee of $20 plus $1 per contract. Which one is the cheapest?
Fig. 9.05(a) below confirms our initial conclusion:
In this hypothetical example broker A would be the cheapest for smaller traders. The break-even point is at 10 contracts. For trade sizes above 10 contracts broker B becomes the cheapest.
Traders who trade in FX options might well think they are not paying any commissions.
That would be a huge mistake. Although there are usually no direct commissions, or relatively small commissions, in trading this type of options the wide spreads could result in even higher commissions than those charged for stock options.
An expansion of the example in Fig. 9.05(b) will explain the issues involved. In this case broker C has been added, who charges no fixed transaction fee and no per contract fee, but the difference between the Bid and the Ask price for this broker is 0.03. For the purposes of this example it is assumed that broker A and broker B have spreads equal to zero, which is useful for comparison purposes.
From the summary above one can immediately see that, despite the fact that he charges no direct fees, broker C becomes more expensive than either broker A or broker B for trades consisting of more than 10 contracts.
While in the real world virtually all brokers will have spreads exceeding 0, a simple spreadsheet will be useful to quickly determine which broker in fact offers the best value for money.