Category Archives: Commissions
Here is a recent post I poached from the Power Dip System blog. It obviously applies to the Power Dip, but the implications can be extrapolated to any trader, either discretionary or mechanical, with a smaller account.
It could be considered in conjunction with this previous post I wrote about commissions: Commission Structures and Small Accounts.
Lets take two hypothetical traders- both with 25K accounts.
Trader A uses a brokerage offering a per-share commission structure of .01/share.
Trader B uses a brokerage offering a per-trade commission structure of 7.00/trade.
We will assume both started trading the Power Dip System on 1/1/2009 and closed all their open trades today. They will have used the baseline model of 1% risk and 10% stop.
Note the differences in the key metrics such as annual return and average trade.
Fixed commissions have shaved over 30% off the average trade.
Commissions are a cost of business. Just like any business costs, if they are too high, they will put you out of business. Trading is a business, and as such, the cost of commissions should not be ignored.
In this study, per-share commissions are superior. However, if these same accounts were to compound over the next decade, eventually per-trade commissions will out-perform per-share commissions as the system starts purchasing very large (many shares) positions.
I’ve had some email conversations with potential subscribers of the Power Dip. Invariably, commissions are a major topic of discussion. I’m going to flesh out some thoughts on commissions and system trading, in part because I think it will be helpful to have as a resource for anyone with a small account who is considering system trading.
There are two distinct commission structures that are available to most retail traders: Fixed Cost and Per Share.
Fixed Cost is what Scottrade uses as a major selling point for its brokerage services (7 buck trades).
Per Share pricing of .005 / share is why Interactive Brokers is well-known (very cheap, great brokerage).
And there are hybrid models, such as one structure that Tradestation offers, where per share prices are .01/share for the first 500 shares, and then .006 for any shares thereafter.
The Size of Your Account and the Way You Trade Should Determine Your Commission Structure-
Small accounts, 10K-30K should consider using a per share commission structure.
Let me give an example of how important this can be for small account traders.
The Power Dip system has made 116 trades since May (5 months), for an average of 23 trades a month. Remember that every closed trade is really two trades- the buy and the sell- and so actually the system has made 232 trades.
Fixed Cost Commissions
($1624/$10000)*100 = 16.24%
If a trader’s account started with 10K, he has now spent 16.24% of his capital on fixed cost commissions, in only 5 months.
Per Share Commissions
I’m using 10% of the actual number of shares as recorded on the Power Dip spreadsheet to approximate the position sizes a 10K account might use.
It is important to remember that the number of shares must be doubled.
($100.95/$10000) *100= 1%
If a trader’s account started with 10K, he has now spent 1% of his capital on per share commissions, in 5 months. This trader has just reduced his cost of doing business by 94% over the trader who used fixed cost commissions.
And the Drawdown Begins with the First Trade-
When system trading it is crucial to have a plan for the worst-case scenario, while expecting a much better outcome. Along this line of thinking, traders should be aware that a drawdown can start with the very first trade. If the account starts with 10K, and immediately trades into a 15% drawdown, fixed cost commission structure will rob the account of another 10-15%. It will not be easy to continue trading a system after a quick 25% haircut. And to make matters worse, as the account loses money, and positions get smaller, the commissions will stay the same!
While fixed cost structure is not so detrimental to a 30K account (5.4% cost of commissions, using the figures from the example above), it still grows a 15% drawdown into a 20% drawdown.
What If You Trade Mostly Cheap Stocks?
For these examples, I will be using 1 month’s worth of trade data from another system I’m trading. The system makes an average of 5 trades a day, mostly on stocks priced in the $1.00-$4.00 range (meaning it will buy/sell a lot more shares than if the shares were more expensive). It has traded 36,900*2 shares since August 31st and made 67*2 trades.
Fixed cost = $5*(67*2) = $670.00 note that I lowered the fixed cost to $5.00
Per share = $.005(36,900*2) = $369.00
The example above shows that for small accounts, a fixed cost structure will be superior to a per share structure IF it trades large positions of cheap stocks. Obviously my system is not trading large enough positions of cheap stocks to benefit yet from fixed cost commissions.
The most effective way to manage commissions may be to split capital into 2 accounts at different brokerages where the fixed cost account is used to trade cheap stocks and the per share account is used to trade more expensive issues.
Commissions are a cost of doing business. As such, they must be managed just as any other business cost would be. Traders with small accounts must be very careful to match their account size and trading style with the appropriate commission structure or they may not be in business for long.