The true cost of commissions and spreads

Many investors forget to account for the cost of commission and spreads in their trading accounts. While $7.95 here and there and a $.20 spread on stocks may seem minimal, the difference can add up quickly, particularly for high frequency investors.

Long term investors

Long term investors who look for large movements rather than short term gains pay the least in commissions, both in dollar amounts and by percentage. One of the major reasons why it is easier to profit in the long term than with short term trading is due very much to the commission and the spread between bid and ask.

For a long term investor looking for a huge percentage gain, paying a few cents on the spread price and ten dollars for a trade is nothing compared to the grand scheme of things. 100 shares of stock in ATT costs $3740 and $8 in commission and will add $3730 in value to your holdings, assuming a $.10 difference between bid and ask.

Short term traders

Short term traders have it the absolute worst when it comes to commissions. Most brokerages charge $8 for a trade, and you must consider a 10-20 cent difference between bid and ask prices. For 100 shares of a company, a short term trader is looking at paying $26-36 just to enter and exit a trade. This would mean that the first $.26 in movement in stock price goes directly towards paying your commissions. If at the end of the day, your 100 shares gain $1 each, you’ve really only earned $64-76. The short term trader gives up much of his or her gains solely to commissions, making it a very difficult way to make a buck.

Evaluating the odds

The long term trader and short term trader pay the same amount in commissions, but an entirely different amount when calculated by percentage. The long term trader looking for a $5 price movement would find that they would only pay 7% of their profit to commissions, while a short term trader looking for a quick $1 change in price would pay 36% of their returns to commissions.

The difference between bid and ask is one of the reasons most traders fail. Those who are accustomed to short term trading do not realize how much of each gain has to be turned over to cover commissions. These kind of high payouts means that the odds are certainly out of the trader’s favor. The long term investor plays with a 7% disadvantage, while the short term day trader is at a 36% disadvantage. Considering the world’s casinos have made billions with a 2% advantage, its not hard to see how so many people fail to turn a profit.

Go long term

If your own trading turns unprofitable in the short term, consider trying it on a longer term horizon. This will allow you to target bigger gains and limit your exposure to fees and the spread. Long term investors are more profitable because of their lower exposure to fees that drastically cut into returns. Going long term make take more time to return a profit, but will greatly increase your returns.