I am old enough to remember a time when the commission on a hundred shares of stock could be $150 or $200. In fact, only a couple of years ago, when teaching a seminar class, an older student in the front row was livid and essentially accused me of lying when I casually mentioned that my commission for a thousand share trade was $9.95. Thankfully, with the advent of the Internet and deep discount brokers, those days of exorbitant commissions are long gone. However, that does not mean that we can ignore the effect of commissions on our trades.

I recently closed one of my trades in the $10 Trader for a small gain. In the Alert I sent notifying that I was closing the trade, I indicated that if my order was filled at my limit it would result in a 2.5% gain. As things worked out, I got a better fill than expected, and actually realized a before commission gain of 4%. Since everyone pays commissions at a different rate, I always set out the percentage on a "before commission" basis. The following day, I received an e-mail from a subscriber who advised that even though my alert indicated a 2.5% gain, he actually lost $4 on the trade. His per-share gain was only $0.10 and he paid a $7 commission going in and a $7 commission coming out. By working backwards, it is evident that the subscriber bought 100 shares of the stock. He realized a $10 gain on the stock, but the cost of the trades in terms of commissions totaled $14. In this situation, the cost of commissions turned a gain into a loss. Of course, it is somewhat unusual to close a trade for a mere $0.10 gain, but in this case, it appeared to me that the stock was going to turn down so I got out with my small profit. In my own situation, I realized a profit even though I was paying a higher commission rate than the subscriber because I was dealing with more shares of the stock. I should note that I also got a better fill going in and a better fill going out than did the subscriber so I made $0.19 a share. However, if we assumed that I only made a gain of $0.10 a share, but had 500 shares instead of 100 shares, I would have realized a $50 gain on the sale of my shares before commissions. I actually pay $9.95 each way so my commissions totaled $20. Even in light of that, I still would have shown a $30 gain. I responded to the subscriber noting the effect of owning a small number of shares.

When I send out an alert, I never include the size of my position for a number of reasons. I have already written about the importance of money management and that management is specific to each individual account. In addition, I am not providing investment advice, but rather showing trades that I like personally for my own accounts. I have no idea what a particular subscriber's risk tolerance may be nor do I know how much money they have to trade nor their level of experience. I pay $9.95 to trade up to a thousand shares of stock and I pay $1.50 a contract (minimum $12.50) for option trades. The fewer shares or the fewer contracts I trade, the more significant the commission becomes. If we look at a couple of examples, we can see what commissions can do to us. Let's say I buy a hundred shares of a $50 stock and the stock moves up 1%. Suppose I pay a $10 commission going in and a $10 commission going out. I have invested $5,000 and with the 1% move, I have a before commission gain of $50. After commissions, I have realized a gain of $30. Suppose, however, that I only bought 10 shares of that stock and realize the same per-share gain. In that event, I would realize the same 1% gain on the stock price, but that would only equal a $5 gain and, including commissions, I would lose $15.

Most people would or should be satisfied with a 2% or 3% gain every couple of weeks. If we could realize any 2.5% gain each month, for example, we would enjoy a 30% per year gain (before commissions and before taxes). However, we need to be aware that when we are entering small positions a 2.5% short term gain after commissions can be very difficult to achieve, particularly with cheaper stocks. For example, let's assume we are buying a $6 a share stock and that we are paying a $10 commission going in and a $10 commission going out. If we buy a hundred shares of the stock, it will cost us $610 to get in and we know that we will have to pay another $10 commission to get out for a total cost of $620. In order to realize a 2.5% return after commissions and before taxes, we need to get $6.35 a share for our 100 shares. However, if we purchased 500 shares instead of 100 shares and paid exactly the same commission, we would only need to sell our stock for $6.19 a share instead of $6.35 a share in order to achieve our 2.5% gain after commissions. In other words, the stock would only have to move 3% to achieve our goal if we bought 500 shares while it would have to move 5.8% to achieve our goal if we only bought a hundred shares.

It is important to keep this concept in mind, particularly when we are buying a relatively low number of shares or relatively few option contracts. Obviously, relatively small commissions have little effect when we deal with a larger number of shares or more option contracts. Of course, the more shares or contracts we have, the greater the risk we take on.

Good Trading!
Bill Kraft

January 27, 2007

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