The Basics

The Cost of Trading

Last week I wrote a post for the Currensee blog addressing a recent SmartMoney article attacking forex trading from the perspective of costs. The article was full of misinformation of the sort I’m coming to expect from those writing about forex (and trading in general) from a journalistic point of view. I wasn’t shy about taking the author and her editor(s) to task for the piece’s short-comings.

One of the core elements of the discussion in my post was the impact of spreads on one’s trading. In the spot forex market spreads are readily visible because that’s how the market presents price feeds. In exchange-traded markets, however, spreads are often quite opaque because it’s traded prices that are the dominant presented part of prices feeds. The fact of the matter is, however, that bid/ask spreads exist in all markets.

Over the last couple days I’ve been collecting spread indications from a wide array of markets at random 15-30 minute intervals during the NYSE trading day (to ensure that all markets involved are open and active rather than including pre-market and other non-primary sessions). Here is the result of the study including some of the most actively traded market instruments.

The equity instruments were selected based on regular inclusion among the most actively traded securities (on a shares basis), so the list includes a couple of index ETFs as well has high profile individual stocks. The Treasuries list includes the current on-the-run securities, meaning the ones most recently auctioned. The futures prices are for the standard contracts except where specifically noted. Prices for the noted forex exchange rates are from the EBS dealing system. All of the above information was derived from real-time prices. (Keep in mind that markets less active than the ones presented here will tend to have wider spreads.)

The Data
I’ve a couple of primary sets of information in the above table. One is the spread. In order to standardize the comparison, I’ve expressed that in terms of the dollar value of the spread relative to a $100,000 trade. Obviously, these securities trade in a wide array of different contract and position sizes, so this isn’t meant to indicate some real-world fixed contract value. The $100,000 was just selected to make the spread values as expressed in dollar terms easy to understand and compare side-by-side. The “Avg $ Sprd/$100k” column shows what the average spread was based on about 30 intraday observations, with the “$ Sprd Rng” column indicating the range of spreads observed.

On the right side of the table I’ve incorporated broker commission estimates to provide a second set of comparative information by way of total trading cost. I’ve used $7.95 per side for the equity trades and $7.95 per round turn for the futures contracts. Brokers often will do commission-free transactions for Treasury trades, so no commission is factored in there. Similarly, zero-commisson trading is readily available for retail forex trading, so no commission is factored in there either. Obviously, the reader can replace what I’ve listed with their own numbers for a more personal comparison.

And the winner is…
If you want lowest cost trading then you want to stick to the short-term interest rate market. Spreads on 2yr and 5yr Treasury Notes are under $10 for a $100k trade, and they average under $3 for 3mo Eurodollar futures (note that this is Eurodollar, not the EUR/USD exchange rate). It’s worth noting that these are the very same markets where my volatility comparison between markets shows the lowest levels of volatility.

Beyond the short-term rates securities, the all-in cost of trading for the major forex pairs holds a modest edge over most of the other instruments included in the study. The futures markets, however, are mostly fairly close. It’s in the individual stocks where we start to see the total costs extend away from the overall group average, largely because of the broker commissions.

Market maker’s dream
Of course the one figure jumping off the page is the spread cost of Citi (C) stock. The bid/ask spread is $0.01, and the stock is (at this writing) trading below $5. That means the spread value is quite a bit higher than the same spread for the Qs trading in the $50s. Now consider that 350-400mln shares of C traded during the period of the study. That’s better than $1.7bln worth of volume. At about $205/$100,000 we’re talking about something around $3.5mln in spread differential per day!

It’s good to be a market maker in Citi shares these days!

Factoring in leverage
Note that in now way is leveraged trading factored into the figures above. They only reflect costs per $100,000 traded. That means costs as related to the value of one’s account is going to depend on how much leverage is being applied. For example, someone trading $100,000 worth of EUR/USD on a $10,000 account (10:1 leverage) will have a cost of about 0.1% ($11.10/$10,000). Similarly, someone trading $100,000 of the SPY on a $25,000 account (4:1 leverage) would have a cost of about 0.09% ($23.14/$25,000). To fairly judge the cost comparison between markets, one needs to do so on the basis of how much leverage is being applied and how frequently trades are being done.

Trader Resources

Motley Fool Acting the Part

I recently had the opportunity to pick up a free copy of the latest Motley Fool book, Million Dollar Portfolio. I’ve never spent much time looking at what the folks at Motley Fool do, though I know their focus is on stock investing. With that and the idea that I could provide my readers with a review of the book when I finished, I decided to go ahead and get it.

I’ve only just started reading Million Dollar Portfolio as part of my daily commute. It will probably take a little while to get all the way through, so you’ll have to wait for a the full review until then.

There is one little thing I need to comment on, however.

At the start of the third chapter, in classic investor book fashion, the authors attempt to demonstrate why a buy-and-hold approach beats a trading approach. Taxes and transaction costs are the noted culprits which make trading much less worthwhile than investing.

Here’s the problem, though.

The example they use is so completely erroneous as to be farcical.

A scenario is offered in which you can either invest $1000 in a stock which makes 7% per year, or you can use that $1000 to play one stock each year that makes 12% per annum. Transaction costs are $10 per side. Short-term capital gains taxes in the U.S. are 15%. Long-term capital gains taxes are not listed, but are said to be higher. The authors claim that the 7% option turns the initial into $6137, while the 12% option actually only gets you up to $3073 after all the transaction costs and taxes which come out along the way.

Seems like a pretty good argument for investing, doesn’t it?

It’s a complete crock!

The numbers don’t work out at all. All we have to do is look at where each portfolio is at after one year to see the error.

At the end of the first year the 7% portfolio is worth $1070 ($1000 x 7%). Actually, if we take out the $10 commission for buying that $1000 worth of stock the real value is $1060.

Where the 12% portfolio value is at in one year depends on the short-term capital gains tax rate. That year’s trade will make $120 ($1000 x 12%). We need to take out $20 for transaction fees, so that leaves a $100 profit. Now, if the tax rate is more than 40%, then the 12% portfolio ends up with a final value lower than than the 7% one. At 40% the two are the same. Any tax rate lower than that the 12% portfolio is the winner.

A little investigating indicates that the top end U.S. short-term capital gains rate is 35%. My calculations indicate that at such a rate the 12% portfolio would end up with a final value close to $9000. That’s considerably better than the $6137 the authors indicate would be the final value of the 7% portfolio (though my calculations put it somewhere closer to $6500).

On top of this funky math, they get even more ridiculous.

Motley FoolThe Motley Fools cite a report from Charles Schwab which says that short-term traders need to make 21.2% more than the longer-term ones to offset the taxes. Somehow they translate this figure to mean it would take a 48% annual pre-tax return to better the 7% portfolio’s results. I really don’t know where they pulled that number from. It clearly, though, has no basis in reality.

I’m not arguing here against the overall contention that longer-term traders have lower transaction cost and capital gains hurdles to overcome. They most certainly do. Traders need to be pretty sure they are going to considerably exceed the returns they would expect to get from a buy-and-hold strategy in order to make trading worth their while. I just have really hard time respecting the conclusions put forward by someone who is so painfully off in constructing their arguments.

Do you have any thoughts about or experience with Motley Fool?