Free Trading - What you Need to Know

​Recently, Charles Schwab announced they would eliminate commissions on trading.  Other major brokerage firms quickly followed with free trading.  Commission rates have been falling for several years so it was just a matter of time.

I remember my dad telling me he used to call his broker to buy a stock and the broker would charge him $130 to make the trade.  This was a huge expense to overcome.  Say you wanted to invest $5,000 in a stock and you expected to earn 10% in a year.  If you pay $130 to buy and $130 again to sell, you are giving up half of your return for the year (~2.5% to buy and ~2.5% to sell).

Even before the latest news of zero commissions, rates were very low.  I was paying $4.95 per trade at E-Trade so I never really gave it much thought.  Obviously, if you are an active trader, it matters more.  When you only make a few trades a month, it’s not a big deal.

Here are some things you need to know in the world of “Free Trading”:

1)      Depending on the brokerage firm, free trades applies to U.S. stocks and ETFs (exchange traded funds). Most likely, you will still be paying commissions on International Stocks and you may be paying for Over the Counter trades as well.  Very low-priced stocks and thinly traded stocks that don’t meet the requirements for the major exchanges trade OTC (over the counter).

2)      You may end up paying higher Bid/Ask spreads.  When you buy a stock, you pay more than the current quoted prices and when you sell, you receive less than the current quoted price.  The difference is called the Bid/Ask spread.  This is the profit that goes to the Specialist/Market Maker.  Their job is to find buyers and sellers for the stock trade.  The size of the spread is based on the supply and demand of the stock being traded.  If you are trading a blue chip like Apple or 3M, the spread might be a penny so no big deal.  However, very small companies or unknown companies can have wide Bid/Ask spreads. I have not researched it, but I heard Robinhood offers commission free trades, but you end up paying higher Bid/Ask spreads compared to the larger more established brokerage firms.

3)      Taxes are still the most significant expense to consider when making trades unless you are trading in an IRA account.  As a basic rule, it’s best to have your losses be short term (<1 year) and your gains long term (> 1 year).  You don’t always have control over this, but if I’m sitting on a nice gain and I plan to sell the stock, I always check my holding period first.  If it’s close to one year, I will hold out to benefit from the lower tax rate on long term gains instead of paying the higher short-term capital gain rate.  If I’m sitting on a loser and decide to give up on it, it’s better to sell before the one-year mark because a short-term loss will save you more on your taxes than a long-term loss. 

4)      Brokerage firms are becoming more like banks.  They can loan out idle cash and make a profit on the spread between the interest rate they pay you and the rate they can charge on a loan.  Today, you should be able to earn close to 2% on a money market account.  However, many brokerage firms pay a small fraction of a percent on idle cash.  Some are as low as 0.1%.  Brokerage firms know that most people don’t pay attention to the rate they are earning on idle cash they are waiting to put back into stocks.   It’s great that commission rates are now zero, but if you are missing out on interest income, you may be worse off than before.

Example:  Let’s say you make four trades per month on average and you carry a $50,000 cash balance in your account.  You will save $238 per year with commission rates going from $4.95 to $0.  However, you are missing out on $1,000 per year by not earning the 2% going rate on cash.  Depending on your cash level, it might be worth the effort to contact your brokerage firm to see if they offer a money market account.  If not, you should consider transferring your cash to someone who does.  With some effort, you should be able to earn close to 2% on your cash.


















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