No one likes transaction costs, but it’s how brokers, the exchanges, and other service providers stay in business. Still, we should focus on minimizing transaction costs because each time we buy and sell something for a profit, the transaction cost takes some of our profit. Each time we sell something for a loss, add the transaction cost to that loss for a bigger loss. Transaction costs is more of an issue for active traders and beginning investors. For beginning investors, I suggest finding brokers with low commissions. You can find brokers with commissions under $5. If you're only investing a few hundred dollars and commissions add up to $20 or more, you can't make much money.
Commissions. The main transaction cost everyone has to deal with is commissions. Each time you buy and sell, you pay a commission. I wrote about the many services and technology brokers now provide. The cost for having these features, along with other fees, are bundled together in commissions. In essence, the more you use a broker’s services to make trades, the more you pay by paying more in commissions. If you trade directly through the web, lower commissions. If you need the assistance of a live broker to help you make trades, you’ll pay even higher commissions (to pay the live broker’s salary).
Bid Ask Spread. Thinking back to Day 10's lesson, everyone in the market is either a buyer or a seller. Obviously the seller wants to sell for the highest asking price while the buyer wants to pay the lowest price with their bid. The difference in the sellers asking price and the buyer's bid price is the Bid Ask Spread. In non-liquid markets, including some forex (currency) markets and pennystocks, the Bid Ask Spread may be huge. If you aren't careful, you could very well buy at the higher Ask price and pay several % more than you wanted. That means you'll need to the stock to go up that much more just to make a profit. Same with selling. If you sell at the lower bid price, for a non-liquid market you may sell at prices several % lower, either losing all your profit or taking a loss. This usually happens if you use market orders when placing your trade. Market orders are the fastest and make your trade at whatever prices are available. To make sure you get the prices you want, use limit orders and stop loss orders with which you can enter specific prices.
Load and No Load Mutual Funds. Some mutual funds and other types of funds also have transaction costs, which you’ll pay on top of the commissions paid to the broker. Mutual funds may charge a fee each time you buy or sell some shares in the mutual fund. This is to discourage investors from actively trading a fund, putting money in and taking money out of the fund, making it hard for the fund manager to know how much money they have to work with. Fees for mutual funds are labeled as “loads.” Thus, funds marked as “no load” means there’s no extra cost to buying or selling the fund. With load funds, you’ll have less money invested from the start because a percentage of the money you invested already paid for the transaction cost, or load.
Taxes. Didn’t think taxes was in here? Taxes aren’t a direct transaction cost, but each time you sell for a profit when your investments are positive for the year, you’ll pay taxes. Taxes won’t add to your losses, but taxes definitely cuts in to your take-home pay.
The moral of this lesson:
Don’t let transaction costs eat away all your profits. Don't let transaction costs become a pile of losses.
Many people make the mistake of making many trades for small profits, only enough to pay for commissions. Those people do a lot of work but end up making little to nothing. Only the brokers made money from commissions. Transaction costs are very real and you must account for it in your investment plan and trading plan. If an opportunity may not even cover the transaction costs, it’s not worth pursuing. The upside for this awareness is you’ll start to look for the best opportunities with the highest payout probability. Don’t waste time on mediocre opportunities. Also, be smart and choose a broker with the right services for you. You don’t want to pay high commissions for a lot of features you don’t need.
ETN (Exchange Traded Notes),
ETF (Exchange Traded Fund),
High Frequency Trading,
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