Trading commissions

What Are Trading Commissions?

Trading commissions are fees charged by a broker or financial institution for executing buy or sell orders on behalf of a client. These charges are a fundamental component of Transaction Costs in financial markets, impacting the overall net profit of an investment. Investors encounter trading commissions when buying or selling various assets, including stocks, bonds, options, and exchange-traded funds (ETFs). The structure of trading commissions can vary significantly, from a flat fee per trade to a percentage of the trade value, or even a per-share charge.

History and Origin

For much of the 20th century, trading commissions in the United States were fixed, meaning all brokerage firms charged the same rates for stock transactions, often set by exchanges like the New York Stock Exchange. This changed dramatically on May 1, 1975, a day often referred to as "May Day" in the financial industry. On this date, the U.S. Securities and Exchange Commission (SEC) enacted Rule 19b-3, which abolished fixed commission rates, ushering in an era of negotiated commissions and increased competition among brokers.⁴

This regulatory shift paved the way for the emergence of discount brokers, which offered lower commission rates in exchange for fewer services, contrasting with traditional full-service brokers. Over subsequent decades, technological advancements and increased competition further drove down trading commissions. A significant milestone occurred in late 2019, when major online brokerage firms, including Charles Schwab and TD Ameritrade, announced the elimination of commissions for online trades of U.S. stocks, ETFs, and options, marking a new phase of commission-free investing for many individual investors.³

Key Takeaways

Trading commissions are fees paid to a broker for executing trades, contributing to the total cost of an investment.
Historically, commissions were fixed, but deregulation in 1975 led to negotiated rates and the rise of discount brokers.
The late 2010s saw a widespread shift to "zero-commission" trading for many online stock and ETF transactions.
While explicit trading commissions for stocks and ETFs are often zero, other costs like regulatory fees, exchange fees, and implicit costs can still apply.
These costs can significantly affect long-term portfolio performance, especially for those engaged in active trading.

Formula and Calculation

While many online trades are now "commission-free," for those transactions where trading commissions still apply (e.g., options, mutual funds, or broker-assisted trades), the calculation is straightforward.

The total cost added by commission to a trade is:

\text{Commission Cost} = \text{Number of Shares} \times \text{Commission Per Share}

\text{Commission Cost} = \text{Flat Fee Per Trade}

When determining the total cost of an investment, the commission is added to the execution price for a buy order and subtracted from the proceeds for a sell order.

Interpreting Trading Commissions

Understanding trading commissions involves recognizing their direct impact on investment returns. For investors, high trading commissions can erode potential capital gains and compound losses. This is particularly relevant for those with frequent trading activity or smaller account sizes, where commissions represent a larger percentage of the total transaction value.

Even with the advent of "zero-commission" trading, it is crucial to recognize that other transaction costs may still be present. These can include regulatory fees, exchange fees, or fees for specific types of securities or services. Investors should always review a broker's fee schedule comprehensively when establishing a brokerage account to understand all potential charges.

Hypothetical Example

Consider an investor, Sarah, who wishes to purchase 100 shares of XYZ equity trading at $50 per share.

Scenario 1: Brokerage charges a flat commission
If her broker charges a flat $4.95 commission per trade:

Cost of shares: 100 shares * $50/share = $5,000
Commission: $4.95
Total cost of trade: $5,000 + $4.95 = $5,004.95

When Sarah later sells her 100 shares at $55 per share, and the same $4.95 commission applies:

Proceeds from shares: 100 shares * $55/share = $5,500
Commission: $4.95
Net proceeds from sale: $5,500 - $4.95 = $5,495.05

Scenario 2: Brokerage offers zero commission
If her broker offers zero commission for online stock trades:

Cost of shares: 100 shares * $50/share = $5,000
Commission: $0
Total cost of trade: $5,000

When Sarah sells her shares at $55 per share:

Proceeds from shares: 100 shares * $55/share = $5,500
Commission: $0
Net proceeds from sale: $5,500

This example illustrates how trading commissions directly impact the total capital required for a purchase and the final proceeds from a sale, thereby affecting the overall return on an investment strategy.

Practical Applications

Trading commissions are a critical consideration for various participants in financial markets:

Individual Investors: For individual investors, particularly those practicing passive investing or with smaller portfolios, high commissions can disproportionately reduce returns. The shift to zero commissions has made investing more accessible and cost-effective for these individuals.
Day Traders and Active Investors: Those engaged in high-frequency trading or active trading benefit immensely from lower or zero commissions, as transaction costs can quickly accumulate and diminish profits.
Brokerage Business Models: The reduction or elimination of trading commissions has forced brokerage firms to adapt their business models, increasingly relying on other revenue streams such as interest on uninvested cash, payment for order flow, or fees for premium services and advice from a financial advisor.
Regulatory Oversight: Regulatory bodies like FINRA emphasize the importance of fee transparency. Brokers are generally required to disclose all fees to customers, including commissions, at the time a brokerage account is opened and provide regular statements detailing transaction costs.²

Limitations and Criticisms

While the move towards lower and zero trading commissions has largely been beneficial for investors by reducing explicit transaction costs, it is not without its limitations and criticisms:

Implicit Costs: The absence of direct commissions does not mean trading is entirely free. Other implicit costs, such as the bid-ask spread, can still impact the effective price of a trade. This spread represents the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask). When commissions are zero, the spread becomes a more significant component of the total transaction cost.
Payment for Order Flow: Many "zero-commission" brokers generate revenue by selling customer orders to wholesale market makers, a practice known as payment for order flow. While this practice is legal and regulated, critics argue it can create potential conflicts of interest, as brokers might be incentivized to route orders to market makers who pay them the most, rather than necessarily securing the best possible execution price for the client.
Other Fees: Despite zero commissions on stock trades, other fees may still apply, such as regulatory fees, options contract fees, or fees for mutual funds. Investors need to be diligent in understanding a broker's complete fee schedule.
Impact on Brokerage Services: The pressure to offer zero commissions has also led some firms to reduce auxiliary services or increase other fees, potentially affecting the overall value proposition for certain investors.
Overall Investment Costs: Even if trading commissions are zero, investors still face other costs like expense ratios for mutual funds and ETFs, advisory fees, and taxes. Morningstar research consistently highlights that the total cost of investing, including all fees, remains a critical factor in determining long-term returns.¹

Trading Commissions vs. Bid-Ask Spread

Both trading commissions and the bid-ask spread are components of the total cost of a trade, but they represent different types of expenses.

Feature	Trading Commissions	Bid-Ask Spread
Nature of Cost	Explicit fee charged by a broker for facilitating a trade.	Implicit cost representing the difference between the highest buy price and lowest sell price available in the market.
Payer	The investor pays the broker directly.	The investor implicitly pays by buying at the ask price (higher) and selling at the bid price (lower).
Transparency	Historically stated as a fixed or per-share fee. Now often zero for common online trades.	Always present in liquid markets, though the size of the spread varies. Not always explicitly calculated by the investor.
Recipient	Brokerage firm.	Market makers (who profit from facilitating trades between buyers and sellers).
Control	Can be reduced or avoided by choosing commission-free brokers or trading less frequently.	Unavoidable when trading, but can be minimized by using limit orders instead of market orders or trading highly liquid assets.

While trading commissions are a direct, visible charge, the bid-ask spread is an indirect cost embedded in the market price. Even when commissions are eliminated, the spread remains a cost that investors incur, particularly for less liquid securities.

FAQs

Q: Are trading commissions still common today?
A: For common online trades of U.S. stocks and ETFs, many major brokerage firms now offer "zero-commission" trading. However, commissions can still apply to other types of investments like options, mutual funds, foreign stocks, or trades placed with a live broker.

Q: How do brokers make money if they don't charge commissions?
A: Brokers employ various strategies, including earning interest on uninvested client cash, receiving payment for order flow (selling customer orders to market makers), charging fees for premium research or advisory services, and charging fees for other products like mutual funds or margin loans.

Q: Do trading commissions affect my investment returns?
A: Yes, trading commissions directly reduce your net return. Each commission paid lowers the profit on a winning trade or increases the loss on a losing trade. Over time, and especially for frequent traders, these costs can significantly impact overall portfolio performance.

Q: What is the difference between a trading commission and other investment fees?
A: A trading commission is specifically a charge for executing a buy or sell order. Other investment fees might include annual account maintenance fees, advisory fees paid to a financial advisor, expense ratios for funds (which are embedded costs within the fund), or fees for specific services like wire transfers.