Stock Trade Transaction Fee - at what point is it worth it

Question

I have a question regarding the transaction fees that brokers charge and to what extend that put a limit on the minimum amount of shares it is worth buying and how often you can/should trade them.

Say, for example, I have £1000 to invest in stock and my broker charges £10 for a transaction to be made.

After a few weeks my selected stock has performed well and I have made around £20, now I want to trade this and try a different stock that's looking profitable. My transaction sheet would look something like:

£1000             initial capitol
-£10              buy stock
-----------
£990              to invest
-----------
+£20              gain
-£10              sell stock
-----------
1000              to invest
-----------
-£10              buy stock
£990              in stock

From this it seems to me that the cost of trading stock is prohibitive on sums in the low thousands if you intend to make relatively frequent trades. Is this just a fact of life, must each transaction >£1000 or >>£20 profit to be worth it?

At what point does it become not worth trading your stock because the fee outweighs the benefit in return?

Thanks

Answer 1

I'm going to assume that you want to be invested all the time and each trade consists in selling a security and buying another one (similar to your example).

How much commissions you are willing to pay depends on several factors, but one way to think about it is as follows. You have a position in stock A and you want to switch to stock B because you think it will perform better. If you think there's a good chance (>50%) that B will outperform A by more than x% then you can happily pay up to x/2% commissions and still make money over a long time horizon.

If you like formulae, one way to express it is:

expected_return = hit_rate * (win_loss_ratio - 100%) - commissions

Where:

• hit_rate is the number of winning trades vs. losing trades. A hit rate of 55% means that out of 100 trades, you make money on 55 and lose on 45.
• win_loss_ratio is the average gain vs. average loss. If on the 55 winning trades you made $110 on average and you lost $100 on average on the 45 losing trades, you ratio is 110%.

Example: if you tend to be right 51% of the time (hit rate), and gain 110% more than you lose on average (win loss ratio), you can see that your expected profit is: 5.1% - commissions, so you could pay 2.5% commissions on entering and closing the position and still make money*.

Unfortunately, common sense, statistics and numerous studies tell us a sad truth: on average, people have a hit rate of 50% and a win/loss ratio of 100%. Which means that their expected profit per trade is 0% - commission.

Based on that crude observation - unless you can prove to yourself that you are better than average - you should aim at reducing commissions paid to your broker as much as possible through:

• low commissions arrangements: in your example you pay 0.5%, which is quite high. You should aim at 0.2% or less (if you pay an amount per share, which is common in the US, you should avoid penny stocks)
• low amount of trading (turnover)

_{* 51% and 110% are not random numbers, they correspond to the results of the top 15% (professional) managers in a research paper using a sample of 215 funds managing $150bn.}

Answer 2

The main question is, how much money you want to make?

With every transaction, you should calculate the real price as the price plus costs. For example, if you but 10 GreatCorp stock of £100 each, and the transaction cost is £20 , then the real cost of buying a single share is in fact buying price of stock + broker costs / amount bought, or £104 in this case.

Now you want to make a profit so calculate your desired profit margin. You want to receive a sales price of buying price + profit margin + broker costs / amount bought. Suppose that you'd like 5%, then you'll need the price per stock of my example to increase to 100 + 5% + £40 / 10 = £109.

So you it only becomes worth while if you feel confident that GreatCorp's stock will rise to that level. Read the yearly balance of that company to see if they don't have any debt, and are profitable. Look at their dividend earning history. Study the stock's candle graphs of the last ten years or so, to find out if there's no seasonal effects, and if the stock performs well overall. Get to know the company well. You should only buy GreatCorp shares after doing your homework.

But what about switching to another stock of LovelyInc? Actually it doesn't matter, since it's best to separate transactions. Sell your GreatCorp's stock when it has reached the desired profit margin or if it seems it is underperforming. Cut your losses! Make the calculations for LovelyCorp's shares without reference to GreatCorp's, and decide like that if it's worth while to buy.