It costs money to trade, and one of the costs is commissions to your broker. No one works for free, but luckily costs have gone down a lot the last two decades. What is a commission in trading, and how important is it?
A commission refers to a fee imposed by a broker or investment advisor when executing trades or providing investment advice for clients in the securities market. The specific commission amount can vary across brokers, influenced by factors such as the traded asset and the type of service provided. Typically, brokers who solely execute trades without making decisions on behalf of clients or offering investment advice tend to charge lower commissions. If you are trading the most liquid assets and instruments, commissions (and slippage) is very low.
In this article, we look at commissions in trading: what it is, types of costs and commissions, no-commissions brokers, how to get “paid” (rebate) a commission, and how it affects your trading performance.
Some key takeaways:
- Picking the right broker for your investment/trading style is important;
- We pay cirka 0.015% for a round trip in commissions when trading high-priced and liquid ETFs; and
- Comparing backtests to live trading, we estimate a cost of 0.01% per round trip in slippage if we stick to the most liquid ETFs.
Please continue reading:
What is a commission?
Commissions are a fee to your broker for executing orders. For example, if you buy 100 shares of SPY, your broker charges you a fee for that and also when you sell. This is a round trip.
Some brokers offer no commissions, like Robin Hood, for example. However, such brokers make money in other ways and thus might not be a better option for you.
Additionally, you need to pay regulatory fees, exchange fees, clearing fees, or pass-through fees.
How each broker passes on these varies from broker to broker.
Why a broker charges commissions
A commission serves as a compensation given to the broker for providing their services to you. By charging commissions, brokers cover the costs associated with offering their services, such as employee salaries, platform maintenance, and exchange licensing fees.
Obviously, if brokers were to eliminate commissions, they would need to find alternative revenue sources to sustain their operations; otherwise, they would not be able to remain in business. Therefore, when a broker advertises commission-free trading, it is important to understand how they make up for this and ensure that you are truly receiving a favorable deal. Unfortunately, this is not easy for retail traders with little experience.
In many cases, brokers compensate for the lack of commissions by widening the spread, which means you may end up paying more in the form of a higher spread than you would have paid in commissions. Additionally, some brokers may seek to earn interest on the funds you have deposited but are not actively using for trading.
While this practice is not inherently problematic, it is crucial to ensure that it does not impact the quality of the broker’s services, such as causing unnecessary delays when processing withdrawal requests.
Types of commissions? Examples
Some brokers charge a fixed fee per order, while other charge a relative fee.
This could, for example, be 9.9 USD to execute an order no matter the size of the order. If you are buying 1 000 SPY or 100 SPY, you pay the same. The commission is fixed no matter what.
This could be 0.01% of the amount, but a minimum of 1 USD (for example). 1 000 shares of SPY is currently worth 435 000, and thus 0.01% equals 43.5 USD.
Instead of a commission based on a percentage, you might be able to pay per share or contracts traded.
For example, Interactive Brokers charges a maximum of 0.85 USD per futures contract traded or 0.0035 per share traded for their IBKR PRO customers.
1 000 SPY worth 435 000 equals 3.5 USD + additional smaller fees, most likely 4-5 USD.
Why do commissions matter?
As someone new to trading, it’s easy to think that if you’ve just found a good strategy, then it’s just a matter of buying and selling and making money.
However, brokerage costs and commissions are extremely important to understand properly if you want to succeed in trading, yet it is rarely discussed. Sometimes it’s the difference between success and failure. Before you start trading, it is important that you have estimated how much you’ll pay in commissions in order to determine your net gains (or losses).
The truth about trading is that strategies are, first of all, very hard to find. If you find a strategy that works, it might not have a large profit margin. This means that if you find an “edge/strategy” on the stock market that you want to start making money on, the profits are rarely much greater than the losses. In other words, to maximize your profits you should keep your costs low. It’s really no different than running any business.
We have traded full-time for over 20 years and we have first-hand experience with how much commissions matter.
Below we have made a diagram that shows the different net results depending on the commission rate. In this chart, the commission for both buying and selling has been deducted for each trade.
How are commissions in trading calculated? Commission example
For example, if you have traded shares worth 10,000 and the strategy has a positive expectancy of 2% gross (before commissions), then the profit is (in the long run) expected to be 200. If commissions are 0.25% of the amount traded each way (both buy and sell), the profit is reduced to 150 (200 -10000*0.25% – 10200*0.25%).
This may not trouble you for one trade, but trading is a numbers game. Commissions eat into your profits.
Another way to calculate commissions is to look at all trades you have completed in the past and divide the gross amount bought and sold.
For example, if you have bought shares for 20,000 and paid a commission of 40, the commission will be 0.20% (40/20,000).
Some brokers have different commission structures to allocate for many types of traders. Some brokers may also have a minimum fee for each transaction, which should also be taken into account.
Commissions: How to choose a broker
Depending on your trading style, you need to pick the right broker. Are you trading big and “infrequently”, or are you trading often and small?
We believe Interactive Brokers is a very good choice for the majority of traders, but also TradeStation. The market has become less fragmented and the brokers get fewer but bigger. There are not many to choose from, especially if you live outside the market you want to trade.
Can you trade without commissions? Is it a catch?
Robinhood has recently revolutionized the trading industry by introducing commission-free trading for cash and margin accounts.
How can they afford to offer commission-free trading?
That’s because they make money elsewhere. This includes margin lending and monthly fees for upgraded services, for example. Moreover, they have also used client funds as collateral to fund their market bets or obtain loans from a bank. While this practice can be advantageous during stable market conditions, it can have catastrophic consequences when the financial system is under stress.
Robinhood’s new customers are automatically assigned margin accounts, potentially exposing them to the risks described above. Customers can manually downgrade their accounts to cash accounts, reducing their exposure to these risks, but very few customers have any idea what they are exposed to when they sign up. We stay away from Robinhood.
Payment of order flow
Another method of making money as a broker is payment for order flow. However, this may result in lower-quality order execution, leading to slightly higher buy prices and marginally lower sell prices. This is very hard to spot for the customer and is, in our opinion, very shady. Thus, you might in reality, pay a lot in commissions without knowing exactly how much. In reality, it might be a commission in disguise.
However, in accordance with SEC regulations, all orders must be executed either at or within the NBBO (National Best Bid/Offer). The NBBO represents the highest displayed bid and the lowest displayed offer across all exchanges in the United States. However, there is an exception to this rule when an order size exceeds the displayed size at the NBBO.
The order flow practice is not limited to Robinhood, and it was a growing source of revenue for brokerages in 2020. For example, TD Ameritrade received $526.59 million in payments for order flow in the second quarter of 2020.
The best broker with the lowest commission for traders
If you are a retail trader, we believe the best option, by far, is Interactive Brokers. Their support is complete and utterly crap, but their technology and commissions rate is the best in class. A couple of years ago we made a review of IB:
The effects of commission fee on your trading performance – commission example
Are commissions important in trading?
Yes, of course. It eats away your profits if they are too high, but sadly, commissions are a part of doing business.
So how much is a realistic commission? That depends on your broker. We recommend using Interactive Brokers and have used them for about 20 years (we have no affiliation with them). Apart from their crappy support, their technology is good and they have (probably) the lowest commissions for retail traders.
This is from their website:
If you are trading ETFs, like SPY and/or QQQ, you realize quickly that commissions are very low. Let’s expand on the IBKR PRO option for US customers:
If you are an IBKR PRO customer, which everyone is eligible for, you pay a minimum of 0.35 USD for an order for the Tiered version.
We are Interactive Brokers customers, and let’s send an order to buy 500 SPY via IB:
Depending on the fill, the commission rate to buy 217 500 USD worth of stock is a max of 2.5 USD. That equals 0.0012% – for a round trip cost of 0.0024%.
However, occasionally you get partial fills, for whatever reasons, and you might also trade some less liquid ETFs/assets.
What are commissions like in practice? Real and live trading
We use Interactive Brokers and TradeStation, and we summarized the total commissions paid by the total worth of ETFs traded for the first five months of the year:
Our spreadsheet reveals that we have paid 0.014% for all shares traded (round trip – all costs included (even software and market data fees, and partial fills for less liquid ETFs)).
However, this number might be significantly higher if you use other brokers, trade other assets, or other types of strategies than we do.
But there is a second commission in trading called slippage that we need to consider:
Commissions are different from spreads (how is commission different from spread?)
When engaging in trading across any market, the spread is a factor that affects your trading capital or profits. This is because you can only buy at the ask price and sell at the bid price, resulting in an immediate reduction in value equal to the size of the spread as soon as you execute a buy order.
This phenomenon is especially evident in the Forex market, where the spread tends to be more stable due to its high liquidity. However, many traders fail to recognize the difference because Forex brokers often increase the spread by adding their commission to it.
The bid-ask spread emerges from the order flow within the exchange itself. Sellers have their asking prices, while buyers have their bid prices. The price quote displayed reflects the lowest asking and highest bid prices, with the difference between them referred to as the spread.
On each level of the spread, there is an unknown volume. What is displayed might be just an indication.
It is essential to understand that although the spread can reduce your profit margin, it is an inherent aspect of trading and is not directly charged by your broker. It differs from commissions, which are fees brokers levy for their services. Nevertheless, certain brokers may directly mark up the spread, particularly in Forex trading. In contrast, in commission-free stock brokerages or trading platforms, market makers may indirectly increase the spread.
Slippage in trading – another form of commission
Slippage is important and let’s give you practical real life examples:
Let’s consider the scenario where you intend to purchase shares of Google. Google’s bid currently stands at 172.05, while the offer is 172.12. To acquire shares of Google, you would need to match the offer at 172.12 or place a lower bid. For instance, if you bid 172.07, there is a risk of not obtaining any shares unless someone accepts your bid.
Slippage in trading represents a hidden cost that backtesting cannot accurately capture. Assuming a negative slippage as a safety buffer is customary when conducting strategy backtests. It is expected that live trading will likely experience negative slippage, and it is also assumed that the strategy’s performance will deteriorate over time.
Slippage also depends on the strategy. If you are trading breakouts, for example, slippage tends to be bigger than for mean reversion strategies.
As a rule of thumb, slippage is a real cost. But that’s why we stick to very liquid assets that have the least spreads, like SPY or QQQ, for example. They are trading at 430 and 360 USD respectively (as of writing) and normally trade with a max of 3 cents between the bid and ask. 3 cents of 430 is 0.007% (0.014% for a round trip).
This means that a very liquid high-priced ETF offers the lowest slippage. If SPY traded at 20 USD (and not 430) and had one cent in bid-ask difference, then slippage would be greater (in percent).
We like to keep track and record all aspects of the trading process. We have several times compared backtests to the executed prices in live trading. We are trading at the close and open of XLP, SPY, and QQQ (and others). In 2021, we compared slippage from live trading to backtesting results. What did we find out?
Slippage for XLP:
Those 50 trades in XLP showed a positive slippage of about 1 cent. In other words, we get a better price than simulated in our backtests!
This was rather surprising, and not expected. A few outliers contribute to this, but overall, we got a better price in 40% of the trades. We expect this to gravitate toward zero or even slightly negative in the future.
Slippage for QQQ:
Unfortunately, our results are not so positive for QQQ:
In QQQ, we have a negative slippage of on average 2 cents per trade, ie. 4 cents on a round trip. This is still a minuscule slippage of 0.01%, far away from ruining any strategy.
Slippage for SPY:
Our third ETF for the day is SPY, the ETF that tracks the S&P 500, the oldest ETF around. Just like in QQQ we have a negative slippage:
In SPY, we have a negative slippage of 1.5 cents on average, 3 cents for a round trip. This is less than 0.01% per trade and has minimal impact on the results.
Please keep in mind that we enter and sell a few seconds before the close (and open):
- How To Enter And Exit Positions At The Close In Amibroker And Tradestation (Daily Bars And OPG And MOC)
Commissions and backtesting
We don’t include commissions and slippage in our backtests. There are two reasons for that:
- Commissions are very low if you choose the right broker for trading. This is explained above in the examples from Interactive Brokers.
- Slippage in liquid ETFs is very low. We have compared backtests to our trading executions, and the differences are not huge if you trade the most liquid ETFs (or futures). Please read slippage in live trading and our comments in the section above.
Commissions and slippage – total costs
If you are using Interactive Brokers and trading very liquid ETFs, what are the realistic costs for commissions and slippage?
We have determined we are paying 0.015% for a round trip (on average). We need to add slippage, which we estimate to be 0.01% based on our comparison of backtests and live trading.
That is 0.025% for a round trip, hardly ruining a trading strategy.
But these are based on very liquid assets, and the costs increase significantly if you trade lower-valued stocks or less-traded stocks/ETFs.
Thus, you need to evaluate the asset you are trading to determine the true cost and not use an arbitrary percentage like 0.1% or 0.05% or whatever you use.
In the long run, your trading journal is invaluable, and you can easily compare costs and results vs. backtesting. The more record-keeping you do, the better decisions you make. We like to keep track of as much data as we possibly can.
However, there is another huge commission to pay:
The biggest commission in trading: trading biases and screw ups
Sadly, the biggest obstacle for most traders is not slippage and commissions but trading biases. The biggest enemy of successful trading is cognitive errors – not commissions or slippag.
No matter how good your trading strategy is, if you cannot push the buttons, you will not succeed. A quantitative trading strategy requires you to submit to the rules and not overrule them. You can’t backtest overriding the trading rules!
Another cost are human or technological screw-ups. This could be due to numerous reasons:
- Bad internet connection (even a VPS is of no help if you don’t have internet);
- Fat finger errors;
- You skip trading because you had a good day yesterday;
- You skip trading because you made a big loss yesterday;
- The broker is down (yes, it happens!);
- The broker changes API settings;
- The time zone you’re trading from goes to daylight saving (EU and US have different timings);
- Being late for the open or close;
- Our partying (“let’s skip today”);
These are just a few mistakes, but we can assure you the list is longer.
Can you get paid a commission? Rebate example
Yes, you can get paid a commission if you add liquidity. On various exchanges, a reward is provided, referred to as a ‘Rebate,’ to incentivize the addition of liquidity. The specific rebate amount can differ across exchanges; however, it is not uncommon for the rebate to exceed the actual transaction cost charged by the broker. In short, limit orders are rewarded, while market orders are charged for removing liquidity.
To add liquidity means that you put in bid and ask orders and wait until someone “hit” you with your order. You add liquidity, and the counterparty does the opposite (remove liquidity). For this, you get paid while the other party pays.
We have covered this in a separate article called rebate trading strategy. Let’s look at the trading statement below for a specific trading day:
The gross profit in row 1 is 18 dollars, the commission rate is 0.4 USD, but the “ECN fee” column is interesting: It says minis 0.84 cents. This means that we received 0.84 cents for this trade. We also paid SEC fees of 0.177 USD and “misc fees” of 0.0886 USD. The calculations are like this:
- Gross profits 18 USD;
- Minus 0.4 USD in commissions;
- Plus 0.84 USD in rebate;
- Minus 0.177 in SEC fess;
- Minus 0.0886 in misc. fees.
In total, we made 18.17 USD on this small trade. Thus, after commissions and fees, our profits got bigger!
The last row is also an example of increased profits after commissions due to rebate. In the rows in between you find the opposite example: we remove liquidity and have to pay.
The rebate strategy is mainly for proprietary traders or “advanced” traders. We traded prop for almost two decades, and the gif-file above is a sample from our clearing sheets during that period.
Additional Trading Expenses
In addition to commission fees, brokers may impose various other charges for their services. While there are several types of fees, the commonly encountered ones include:
- Platform fees: Certain brokers require traders to pay for using their trading platforms, notably if the trader is not registered for brokerage services. However, for traders who are already clients of the broker, the essential functions of the trading platforms are usually offered free of charge, with premium features available at an additional cost.
- Data fees: Some platforms, like TradeStation, offer live market data and limited historical data. However, traders often need a comprehensive historical data set to backtest strategies and systems effectively. Subscribing to a data service becomes necessary to access the required historical data.
- Overnight charges: In Forex and futures markets, brokers commonly apply overnight swap fees. These fees account for the risk of keeping a position open overnight. Trades closed within the same day are not subject to overnight charges.
Commission in trading – what is realistic to pay? Conclusion
What you pay in commissions depend on your broker, your trading style, the assets you trade, and also the size of the account (bigger accounts are not required to pay minimum fees).
The best advice we can give is to keep track of all your data. Compare your backtests to actual live trading and find out the real commission costs.