Why Your Broker's Commission Is Making You Broke

When it comes to Wall Street, everyone wants to make money. However, the few people who always seem to make money, whether in boom times or in the deepest of economic recessions, are the brokers. Whether they charge commissions or work on a spread, your broker may be making more from your trading strategy than you are.

Below are two strategies that are draining investor pockets right and left, and solutions for combating each.

The Long Haul ETF Buyer

While exchange-traded funds have their benefits in lower expense ratios, that's only half the story. In fact, a number of investors moving funds from their broker's mutual funds to their own selection of exchange-traded funds are likely getting eaten alive by commissions.

Exchange-traded funds, to a broker, are just like stocks, and each buy or sell order is met with a trading commission ranging from a few dollars on up to $40 and more through traditional brokers. Compare that cost to mutual funds, which are free to buy or sell through most brokers.

However, where ETF buyers really feel the pinch is with automatic investments with each pay. Assuming that an ETF investor invests $1000 per month in bi-weekly investments in four different funds, the investor incurs eight commission fees. That comes out to 96 trades per year for a minimum of $960 in costs, or 8% of the total amount invested. At that price, it will take eight years before the difference in expense ratios between mutual funds and exchange-traded funds finally make a difference in his or her account balance!

Solution: A number of discount brokers are allowing commission free trades on a select offering of exchange-traded funds. Consider swapping for a similar, but related fund on the commission free list, or if worse comes to worst, making investments each month, rather than each pay.

The Short Term Forex Trader

Possibly even more than the long term ETF investor, the short term forex trader is most affected not by broker commissions, but by the spreads.

Just like any other business, the cost of business has to be included in profit and loss. That is, when you incur a trading fee, it should be accounted against your earnings as a loss, since it’s a required cost of speculation. For the short term forex trader, broker spreads are one of the largest single item expenses, and they generate the largest costs as a percentage of profits.

However, this isn’t due to the fact that forex traders use their broker more than other traders. Instead, short term forex traders pay more in spreads because of their short term horizon. A trade with a take profit of 10 pips and a spread of 3 pips will shed 30% of its profit potential due solely to the spread. To earn ten pips, the pair will have to rise or fall 13 pips. To lose ten pips, the price only has to rise or fall by 7 pips.

This large broker spread as a portion of the trade is why so many short term forex traders with profitable back-tested strategies find that in the future testing, the strategy isn't so profitable. Broker commissions and spreads can and will devour whole trading systems if they don't earn enough of your attention. Before using a new strategy or money management technique, absolutely be sure to include the cost of the trade in your algorithms. Otherwise, your newly found strategy may be profitable only in a world where everything is free, and if everything were free, it'd be unlikely that you'd need to trade in the first place.
Tim Ord
Ord Oracle

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