Last Updated on 23 July, 2024 by Trading System
There are different types of fees that your online broker may charges when you have an active trading account. One of them is commission, and the amount varies from broker to broker and can impact your returns and your overall experience. But what is commission in trading?
A commission is a service charge levied by a broker or an investment advisor for buying or selling securities on behalf of a client or for providing investment advice to a client. The amount charged in commission varies between different brokers, depending on the asset being traded and the type of service being offered. Generally, execution-only brokers tend to have lower commissions since they don’t decide trades on their client’s behalf or offer investing advice.
In this post, you will learn the following:
- What commission in trading is all about
- How commission is different from spread
- Why brokers charge commissions
- Different methods a broker can charge a commission
- Commission fee calculator: how to calculate commission
- Other trading expenses
- How to keep commission fee and other trading cost low
What is a commission fee in trading?
A trading commission is a charge levied by an investment broker — such as a stockbroker, Forex broker, or futures broker — for making trades on a trader’s behalf. It can also be defined as a service charge collected by an investment advisor for providing investment advice or handling purchases and sales of securities for a client.
The levels of commissions charged per trade vary between different brokers and tend to depend on the asset being traded and the type of service being offered. However, for the most part, discount brokers who only execute trade orders without offering investment advisory services tend to have lower commissions because they do not participate in their client’s trading decisions.
When it comes to investment advisory services, there are important differences between commissions and fees, especially in the way professional advisors use those words to describe their services. While a commission-based investment advisor makes money by selling investment products, such as mutual funds and annuities, and conducting transactions with the client’s money, a fee-based advisor charges a flat rate for managing a client’s money. Generally, this may be a dollar amount or a percentage of the total assets under management. However, when it is sales between family members, which are often gifts of equity, it is usually not commission-based.
For retail stock, forex, options, or futures trading, a brokerage commission charge is a brokerage fee that is charged when you buy or sell a security. So, you pay commissions when buying and selling financial assets and derivatives, like options or exchange-traded funds. In the equity market, the commissions for selling shares can be structured per-trade (buffet) or per-share (ala-carte). The per-trade rates may also be referred to as flat-rate commissions. More on this later.
To put it all together, we can say that full-service brokerages charge commissions for both trading and advisory services, while commission-based advisors make money from buying and selling products on behalf of their clients. When considering a brokerage or advisor, take your time to understand their commissions for services.
How commission works and the effects it can have on your trading
Actually, full-service brokerages make much of their profit from charging commissions on their clients’ trades. The commission fee varies widely from broker to broker, with each having its own fee structure for various services. Hence, it’s important to factor in the cost of commissions when evaluating your profits and losses from selling a stock so as to know the accurate value.
Basically, here is how the trading commission works: when you place a trade order — say you buy a stock — your broker charges a commission for that transaction. Similarly, when you close the trade (sell the stock), the broker charges another commission for the transaction. So, for a complete trip — buying and selling — you are charged commission twice.
Furthermore, commissions may be charged if an order is filled, canceled, modified, or even expired. Normally, when an investor places a market order that goes unfilled, no commission is charged, but if the order is canceled or modified, the investor may find extra charges added to the commission. Even limit orders that go partially filled often will incur a fee, but this may be on a prorated basis.
https://www.quantifiedstrategies.com/commission-in-trading/
The effects of commission fee on your trading performance
Of course, huge commissions can eat into your profits and worsen your losses, and here is how: Let’s say you buy 200 shares of Nokia at $4.50 each, and your broker charges a 2.5% commission for the transaction. So, you pay $900 for the shares and $22.50 in commissions. Some months later, the stock has appreciated 10%, and you decide to sell all your shares in the stock. The broker charges a 2% commission for selling, so you will pay another $19.80 in commissions. In effect, while your investment made a $900 profit, you have paid $42.30 in commissions on the two transactions. Your net profit, therefore, is only $47.70. Similarly, assuming the stock tanked, and you sold, your losses would have increased due to commissions.
Some online brokerages offer flat-rate commissions, such as $9.99 per trade, which may is better when you are buying higher volumes. Interestingly though, many brokers now offer commission-free trading for stocks and ETFs, which means that you can trade those assets without worrying about commissions. However, the spread may be a bit larger than usual.
For advisory services, while a fee-based advisor charges a flat rate for managing a client’s money, a commission-based advisor makes money by selling investment products and conducting transactions. As a result, online discount brokerages and robo-advisors are gaining popularity in recent times, as many of them charge a flat fee for trades — often between 0.25% and 0.50% per year of assets managed. Their services provide you with access to stocks, index funds, exchange-traded funds (ETFs), and more on a user-friendly platform for self-directed investment. They are unlike the core brokerage firms — while online brokerage services also provide a wealth of financial news and information, they offer little or no personalized advice. Thus, some rookie investors may not find things easy with the usual discount brokers, even though the commission is lesser.
Yes, brokers charge a commission when you buy or sell stocks or any other security, such as options, and ETFs, but as we hinted earlier, they adopt different models for charging commissions. While the rates vary by brokerages and financial products, there are two primary commission structures when it comes to stock trading, and they are:
- Per-trade (buffet)
- Per-share (ala-carte)
Per-trade commission pricing
Also known as flat-rate commissions, per-trade commission pricing charges the client per trade, up to the specified maximum share size. It’s like an all-you-can-eat buffet, where those who don’t eat much pay the same as heavy eaters. So, it favors the heavy eaters. In the stock trading context, the per-trade pricing model favors large size traders. The model can be great for less active traders and swing traders who do not plan to scale in and out of positions.
Brokers that operate the per-trade commission pricing model often route their trade orders to a pre-determined designated liquidity provider, with which they must have negotiated an order flow agreement. Since traders are not afforded the ability to target specific ECNs or route directly to a preferred liquidity provider, there may be issues of poor price fills.
The commission rate may seem cheap, but the main issue is in the poor order fills and liquidity because the broker may have an order flow deal with only a single liquidity provider. As you would expect, this can be the difference between getting an entry filled quickly at a good price and having to pay a higher price on the fill, or simply not getting filled.
Furthermore, per-trade pricing can be quite expensive when it comes to scaling in and out of positions — more like a person with a small appetite regularly dining at buffets, but only able to consume a single plate. For instance, let’s assume that you bought 2,000 shares in two trades through a flat-rate broker and now want to scale out of your position by selling 400 shares per time. If this broker charges $9.49 per trade in commission, each order would cost you $9.49. So, the two buy orders would cost $18.98, while the five sell orders would cost you $47.45. All seven transactions would cost you $66.43. Assuming you made a gross profit of $150 from the stock, the commission costs would leave him with only $83.57 net profits. So, you would have paid over 44% of your profit in commissions.
Thus, the per-trade commission pricing model benefits only traders that trade large size positions. If a trader regularly trades 10,000 shares at a time, he would only pay $9.49 at the flat rate, instead of paying $40 at the per-share rate of 0.004/share.
The per-share commission pricing model allows the trader to pay a certain amount per share traded as the commission. With this structure, the trader pays only for the shares they trade. So, it is the ala-carte version of commission schedules whereby a diner (in this case, trader) only pays for what he/she consumes (trades). Thus, traders who trade in huge volumes will find it expensive to pay per share, while active day traders who plan to scale in and out of positions throughout the day will find the commission structure more efficient.
Generally, per-share pricing brokers tend to offer direct-routing access to multiple ECNs, market makers, dark pools, exchanges, and liquidity providers, but the number of different accessible routes varies by broker. Most of these brokers offer their own smart routing feature that will search out the best route to ensure liquidity.
For example, a day trader paying a $0.0025 (a quarter of a penny) per share commission rate would pay $2.50 for each of the initial buy orders for 1,000 shares — that is, $5.00 for the 2,000 shares. On the other hand, each 400 share sell order would only close $1.00 resulting in a total commission cost of $5.00 for the five sell orders. So, in total, he has spent only $10.00 for all the seven trades (buying and selling). When you subtract the $10.00 paid in commissions from the $150.00 gross profit on the trades, the trader would be left with a $140.00 net profit. That is, commissions would have only cost him 6.67% of total profits. As you can see, this is why active day traders normally prefer a per-share commission model.
Generally, the per-share commission pricing model is most suitable for day traders who use a scaling order strategy by buying and selling in a smaller number of shares to favorably adjust average share prices. Some brokers allow for a scaled commission structure where the per-share commission rate gets cheaper when a higher monthly share volume is traded. Those are the sort of brokers that suit high-volume day traders and high-frequency scalpers.
How is commission different from spread?
When you are trading any market, your trading capital, or profits, takes care of the spread because you can only buy at the ask price and sell at the bid price. As a result, you are already down by the size of the spread the moment you hit that buy button. This is more clearly noticed in the Forex market where the spread is much more stable due to huge liquidity in that market. But because Forex brokers often mark-up the spread with their commission, many traders fail to realize the difference.
The bid-ask spread arises from the order flow at the exchange itself. The sellers have their asking prices, while the buyers have their bid prices. The lowest asking price and the highest bid price are what is displayed as the price quote, and the difference between them is called the spread. As you can see, even though the spread also eats into your profit, it is just an inherent part of trading. It is not charged by your broker, and it is different from commissions, which is a fee the broker charges for its services. However, some brokers either directly (as it’s seen in Forex trading) or indirectly via the market makers (commission-free stock brokerages/trading platforms) mark up the spread when they don’t charge commissions.
Why brokers charge commissions
As we stated earlier, trading brokers charge commissions as a part of their service fees. A commission is a reward you give a broker for offering its services to you. Brokers charge commissions to cover the costs they bear in offering their services to you. It is from the commissions and other charges that they can pay their workers, set up their platforms, and renew their licenses with the exchanges.
If the brokers don’t charge commissions, they will have to devise another way to make money, otherwise, they will be out of business. So, when a broker offers you commission-free trading, try to find out how else it is making up for it to be sure you are actually getting a good deal. Most times, the broker may have marked up the spread, so what you don’t pay in commissions, you may end up paying more than that in the spread. Some may try to earn interest on your capital when they are not in use. While there may not be anything wrong with that, make sure it doesn’t affect their services to you — for example, an unnecessary delay when you make a withdrawal request.
Different methods a broker can charge a commission
Apart from the different types of commissions we discussed earlier, we have also stated that some brokers charge their commissions separately and others add the commissions to the spreads. The different methods are seen across all markets — stock, Forex, and futures markets — but how they implement them may be different.
Generally, when the broker charges commission separately from the spread, traders pay the commissions according to the broker’s commission structure, which can be per-trade or per-volume. It is about the same everywhere. But when the commission is added to the spread, the approach is different in different markets. In the forex market, because the market has no central exchange, brokers have the liberty to quote their own spreads. So, to mark up their spreads to accommodate their commissions is easier, and they do it in-house, within their trading platforms.
The stock market, on the other hand, is well regulated and has designated exchanges where the securities are uniformly traded. Trading platforms and brokerages, such as Robinhood and TD Ameritrade, which offer commission-free stock and ETF trading don’t just mark up the spreads themselves; instead, they pass the orders from their platform to market makers who route marked-up spreads to them. The point is, the spreads are usually higher for any brokerage that offers commission-free trading.
Commission fee calculator: how to calculate commission
The way you calculate what you pay in commission depends on the commission pricing model your broker uses — per trade or per-share. If the broker uses per-trade pricing, what you pay in commissions is exactly what the broker charges, but that is only for one trade (buying). When you want to sell, you will still pay another commission for that trade. So, to get the total cost of commissions for a round-trip, you add the commission for buying and the commission for selling. You can subtract that to whatever profit you made to get your net profit or add it to your loss to get your total loss.
In a situation where the broker uses a per-share pricing model, to get the total commission cost for each trade, you have to multiple the number of shares traded by the broker’s per-share commission. As in our example above, if the broker charges $0.0025 per share in commission and you buy 10,000 shares, you will pay a $25 commission for buying the stock. When you sell all the 10,000 shares, you pay another $25. So, the total cost of the round trip is $50, which you must subtract from whatever profit you made to get your net profit. If your trade was a loser, you have to add the total commission to the loss to get your total loss.
Other trading expenses
Apart from commission fees, brokers may also charge other fees for other services they provide. While there are many different forms, the common ones are as follows:
- Platform fees: Some brokers charge traders for providing the trading platform they use for trading. This is often the case when the trader is not registered with them for brokerage services. For traders who are also their brokerage clients, most brokers provide them with the basic functions of their trading platforms for free while offering the advanced features for a premium.
- Data fees: Some platforms, such as TradeStation, also offer live market data and some historical data. However, to get enough historical data for backtesting strategies and systems, the trader has to subscribe to a data service.
- Overnight charges: In the Forex and futures markets, most of the brokers charge what they call overnight fees. The fee is used to cover the risk of leaving the position overnight. Trades that are closed the same day are not charged overnight fees.
How to keep commission fee and other trading costs low
If you want to trade stocks or build a stock portfolio on your own, the key thing you can do to lower your trading costs is to look for brokers that charge the lowest fees while still offering the best services. But more importantly, you should understand your trading style and choose a broker that offers a commission model that suits that style of trading.
For example, if you a day trader who scales in and out of positions, it is preferable to use a broker that offers per-share commission pricing, but if you are a position trader who places a high-volume trade at once and few times in a year, you are better off with a per-trade pricing broker.
Other ways to limit trading costs while investing is to invest in ETFs rather than individual stocks, as well as make use of automated investment platforms known as robo-advisors. Robo-advisors help cut down on your expenses because they are automated, and as such, they can be great for small investors.
FAQ
What is a trading commission, and how does it impact my trading experience?
A trading commission is a service charge imposed by a broker for executing trades on behalf of a client. The amount varies between brokers and can affect your overall returns and trading experience. Brokers may charge commissions based on the type of asset being traded and the services provided. Different brokers have varying fee structures, and understanding them is crucial for evaluating trading costs.
How do commission-based investment advisors differ from fee-based advisors?
Commissions are fees charged by brokers for executing trades, while spreads represent the difference between the buying (ask) and selling (bid) prices in the market. Both can impact trading costs. Commission-based advisors earn money by selling investment products, while fee-based advisors charge a flat rate for managing a client’s money. Understanding these differences is essential when choosing financial services.
How do brokers calculate commissions, and is there a commission fee calculator available?
Beyond commissions, brokers may charge platform fees, data fees, and overnight charges. Understanding these additional costs helps traders make informed decisions. Providing insights into the calculation of commissions, including examples for both per-trade and per-share models, helps traders understand their total trading costs.