Skip to main content
diversification.com
← Back to C Definitions

Commission rates

What Is Commission Rates?

Commission rates refer to the fees charged by a brokerage firm or financial professional for executing transactions on behalf of a client. These rates are a fundamental component of transaction costs within financial markets, directly impacting the overall profitability of an investment. Historically, commission rates were a primary source of revenue for brokers, covering the cost of trade execution and often bundled services like research or advice.

History and Origin

For nearly two centuries, the United States stock market operated under a system of fixed commission rates, where the cost of executing a trade was standardized and set by exchanges like the New York Stock Exchange (NYSE). This meant that all brokerage firms charged the same fee for a given transaction size, regardless of the effort involved or the services provided16, 17. For instance, buying 100 shares of a company would incur the same commission at any firm15.

This fixed-rate system was abolished on May 1, 1975, a date widely known as "May Day," when the Securities and Exchange Commission (SEC) mandated the end of fixed commissions in favor of competitively negotiated rates12, 13, 14. This deregulation was a pivotal moment, aiming to increase competition among brokers and reduce trading costs for investors11. The SEC's decision allowed brokerage firms to set their own commission rates, leading to a dramatic reduction in fees over time and ushering in the era of discount brokers. Charles Schwab, for example, was among the pioneers who embraced these new rules, offering significantly lower fees than traditional firms9, 10. The history of fixed commission rates and their abolition can be further explored through resources like the SEC Historical Society. [https://www.sec.gov/about/sechistorical-society-galleries/sec-1973-1981-mayday]

Key Takeaways

  • Commission rates are fees charged by brokers for executing financial transactions.
  • Historically, commission rates were fixed by exchanges, but this changed in 1975 with SEC deregulation.
  • The abolition of fixed commissions led to increased competition and significantly lower transaction costs for investors.
  • While many brokerage firms now offer "zero commission" trades on stocks and ETFs, other fees or forms of compensation may still apply.
  • Understanding different types of commission rates and associated fees is crucial for evaluating the true cost of investing.

Formula and Calculation

Commission rates can be calculated in various ways, depending on the asset being traded and the brokerage firm's fee structure. While specific formulas vary, the general concept involves a percentage of the transaction value, a flat fee per trade, or a per-share/per-contract fee.

For a flat-fee commission:
Total Commission=Fixed Fee Per Trade\text{Total Commission} = \text{Fixed Fee Per Trade}

For a percentage-based commission:
Total Commission=Transaction Value×Commission Rate (as a decimal)\text{Total Commission} = \text{Transaction Value} \times \text{Commission Rate (as a decimal)}

For a per-share or per-contract commission:
Total Commission=Number of Shares/Contracts×Fee Per Share/Contract\text{Total Commission} = \text{Number of Shares/Contracts} \times \text{Fee Per Share/Contract}

Where:

  • Transaction Value refers to the total monetary value of the securities bought or sold.
  • Commission Rate (as a decimal) is the specified percentage expressed as a decimal (e.g., 0.01 for 1%).
  • Number of Shares/Contracts is the quantity of equities or options contracts involved in the trade.

Interpreting the Commission Rates

The interpretation of commission rates has evolved significantly. In the era of fixed commissions, investors primarily evaluated the total cost of a trade against the perceived value of bundled services, such as financial planning and research, provided by a full-service broker. With the advent of competitive pricing, the focus shifted towards minimizing direct trading expenses.

Today, while many retail investors see "zero commission" trades advertised for stocks and Exchange-Traded Fund (ETF)s, it is important to understand that brokerages may still earn revenue through other means, such as Payment for Order Flow (PFOF) or various account-related fees7, 8. Therefore, interpreting commission rates now involves looking beyond the headline figure to understand the complete fee schedule and how a brokerage firm generates its income from client activity.

Hypothetical Example

Consider an investor, Alice, who wants to purchase 100 shares of Company X at $50 per share through her online brokerage firm.

Scenario 1: Flat Fee Commission
If the brokerage charges a flat commission of $5 per trade, regardless of the number of shares:
Total Commission=$5.00\text{Total Commission} = \$5.00
Alice's total cost for the trade would be $5,000 (100 shares * $50) + $5 = $5,005.

Scenario 2: Per-Share Commission
If the brokerage charges $0.01 per share:
Total Commission=100 shares×$0.01/share=$1.00\text{Total Commission} = 100 \text{ shares} \times \$0.01/\text{share} = \$1.00
Alice's total cost for the trade would be $5,000 (100 shares * $50) + $1 = $5,001.

Scenario 3: Zero Commission (with potential other charges)
If the brokerage advertises "zero commission" for stock trades:
Total Commission=$0.00\text{Total Commission} = \$0.00
Alice's direct trading cost would be $0, making her total cost for the shares $5,000. However, Alice should still review the brokerage firm's fee schedule for other potential charges, such as regulatory fees or account maintenance fees, which are separate from trading commissions. This scenario highlights how seemingly free trades may have indirect costs or alternative revenue streams for the broker.

Practical Applications

Commission rates are a critical consideration for investors across various aspects of the financial landscape:

  • Retail Investing: For individual retail investors, low or zero commission rates on stocks and ETFs have made frequent trading more accessible and affordable, democratizing access to the stock market. This shift has particularly benefited those engaging in active strategies or dollar-cost averaging.
  • Portfolio Management: Fund managers and institutional investors analyze commission rates as part of their overall transaction costs, which directly impact portfolio performance. Negotiated commission rates are common in institutional trading.
  • Brokerage Business Models: The evolution of commission rates has forced brokerage firms to adapt their business models. Many have shifted from commission-based revenue to asset-based fees, subscription models, or alternative income streams like Payment for Order Flow.
  • Regulatory Oversight: Regulatory bodies like the Financial Industry Regulatory Authority (FINRA) require brokerage firms to disclose their fees transparently and ensure that their advertisements regarding "free" or "no-fee" services are not misleading5, 6. FINRA's Regulatory Notice 13-23 provides guidance on how firms should disclose fees in their communications to avoid misleading investors. [https://www.finra.org/rules-guidance/guidance/regulatory-notices/13-23]

Limitations and Criticisms

While the shift to lower or zero commission rates has largely benefited investors by reducing direct transaction costs, it has also introduced new complexities and criticisms:

  • Hidden Costs: The most common criticism is that "zero commission" does not mean "free." Brokerages may generate revenue through other avenues, such as Payment for Order Flow (PFOF). In PFOF, a brokerage firm receives compensation from a market maker for routing customer orders to them3, 4. Critics argue this could create a conflict of interest, as the broker might prioritize the rebate over achieving the best possible price (best execution) for the client's trade, even though many firms claim price improvement for customers2. For more details on this practice, Investor.gov provides a comprehensive explanation. [https://www.investor.gov/introduction-investing/investing-basics/how-market-works/payment-order-flow]
  • Reduced Services: The decline in commission rates often corresponds to a reduction in services offered by discount brokers compared to full-service brokers. While this suits self-directed investors, those seeking personalized advice, in-depth research, or dedicated client support may find these "zero-commission" platforms insufficient without additional fees.
  • Increased Trading Frequency: Lower commission rates can incentivize more frequent trading among retail investors. While active trading can be a valid strategy, excessive trading without a sound basis can lead to higher cumulative transaction costs (from other fees or bid-ask spread erosion) and potentially poorer returns for some individuals.
  • Market Liquidity Concerns: Some argue that PFOF practices, enabled by zero commission rates, could affect market structure and liquidity, particularly for less liquid securities, though research on this remains ongoing1.

Commission Rates vs. Payment for Order Flow

While both commission rates and Payment for Order Flow (PFOF) relate to how brokerage firms earn revenue from client trades, they represent distinct mechanisms.

Commission rates are direct fees charged to the client for executing a buy or sell order. Historically, these were explicit charges, either fixed or percentage-based, visible on a trade confirmation.

Payment for Order Flow, on the other hand, is compensation a brokerage firm receives from a market maker for directing client orders to that specific market maker for execution. This compensation is typically not paid by the client directly but rather from the market maker to the broker. The existence of PFOF has been a key factor enabling many brokers to offer "zero commission" trades to retail investors. While commissions are a direct cost to the investor, PFOF is an indirect revenue stream for the broker, which may or may not impact the investor's execution price.

FAQs

How are commission rates typically charged?

Commission rates can be charged as a flat fee per trade, a percentage of the total transaction value, or a per-share or per-contract fee. For example, some brokers charge a flat $5 fee for stock trades, while others might charge $0.005 per share, or $0.65 per options contract. The specific method depends on the brokerage firm and the type of securities being traded.

Why do some brokerage firms advertise "zero commission" trades?

Many brokerage firms advertise "zero commission" trades for stocks and ETFs to attract retail investors. While no direct commission is charged to the client for these specific trades, the firm may still generate revenue through other means, such as Payment for Order Flow, interest on cash balances, or fees for premium services. It's important to review the full fee schedule of any brokerage firm.

Are there other fees besides commission rates I should be aware of?

Yes, even with "zero commission" trades, investors may encounter other fees. These can include regulatory fees (like the SEC fee or FINRA Trading Activity Fee, which are typically passed through to the investor), account maintenance fees, inactivity fees, wire transfer fees, mutual fund expense ratios, or fees for broker-assisted trades. Always read a brokerage firm's fee schedule carefully to understand the total cost of your investment activity.