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You just finished signing up for a stock picking site and you are ready to make the big bucks. You didn't blindly believe the claims of 50% annual gains, you checked the date stamps of all the previous recommendations and ran the numbers yourself. Then you set out and trade.

After the first month of trading, you stare at your account is disbelief thinking there must be some mistake - while the stock picks are up an average 2% you are down 2%! You rebalance and trade again feeling sure that this is just an anomaly. The second month you are profitable…barely. Yet the stocks supposedly jumped 6%! What is wrong? You are learning about trading costs. What is the true cost of trading and how can you manage it?

Excess Gains Hitting a Brick Wall

The following chart shows the compounded theoretical returns of a certain strategy that targets small upgraded stocks in bull markets. According to this backtest, we could have turned $10,000 into $75 million in just 11 years.

click to enlarge

Hmmm, that doesn't seem right... is this expectation rooted in fantasy or reality? What would we really have made?

On closer inspection, we are trading some very small market capitalization stocks. Just look at the chart below to the 15 stocks traded over the two week period starting on March 12th, 2012.

Ticker

Name

Pct

Rank

MktCap

Vol10DAvg

(NYSE:ASGN)

On Assignment, Inc.

27.86

98.98

499.53

0.22

(NASDAQ:ERT)

eResearch Technology, Inc

14.08

92.07

333.37

0.42

(NASDAQ:ABCB)

Ameris Bancorp

12.28

81.21

284.3

0.07

(NYSE:LF)

LeapFrog Enterprises, Inc.

10.88

96.54

489.24

0.56

(NASDAQ:DUSA)

DUSA Pharmaceuticals, Inc.

7.26

85.07

149.38

0.38

(NASDAQ:FRME)

First Merchants Corporation

7.19

86.91

319.64

0.1

(NYSE:GCA)

Global Cash Access Holdings, Inc.

5.66

96.88

425.87

0.96

(NASDAQ:TAST)

Carrols Restaurant Group, Inc.

4.58

95.1

278.61

0.1

(NASDAQ:UEIC)

Universal Electronics Inc

4.41

81.31

284.95

0.05

(NASDAQ:USHS)

US Home Systems Inc

3.82

91.94

84.72

0.56

(NASDAQ:BOOM)

Dynamic Materials Corporation

2.23

79.15

294.45

0.05

(NYSE:XOXO)

XO Group Inc

2.14

85.32

268.47

0.38

(NASDAQ:NATR)

Nature's Sunshine Prod.

-1.99

83.43

257.8

0.06

(NASDAQ:TGE)

TGC Industries Inc

-2.23

98.79

205.29

0.24

(NASDAQ:TESS)

TESSCO Technologies, Inc.

-2.34

93.59

183.51

0.05

AVERAGE

6.39

290.61

0.28

This strategy produced a theoretical 6.39% return in 2 weeks while the market only gave 2.7%, which means this strategy outperformed by 3.69% in 2 weeks. Please note, however, that the average market cap is less than 300 million and the average volume is less than 300,000 shares daily. How will this affect our trading?

The Investment Technology Group's Global Cost Review for the 3rd quarter of 2011 presents some interesting statistics regarding the true cost of trading. According to common definitions, this is a micro-cap strategy (or less than 300 million market cap). What sort of additional costs would this impose upon our trading?

  • Average slippage costs for micro-caps are 1.67%
  • Average commission fees for micro-caps are 0.24%
  • Combined cost is 1.91%

For those of you unfamiliar with the term, slippage is the impact you have when buying or selling shares. The less liquid the stock or the more capital you invest, the more pronounced this effect will become. If share prices were at $10 and you placed a 'Buffett-sized' market order to buy every share in sight over the next half hour, you could double the share price temporarily. After your buying frenzy and when share prices settle back down to normal, you would have experienced 100% slippage.

Keep in mind that all quoted numbers from the ITG Global Cost Review are averages and much depends on the actual trading practices. Using these figures, how will our gross gain be affected during our blockbuster trading period with 6.39% gain? Assume the following:

  • $50,000 trading capital
  • Average 250 shares per stock
  • Slippage for buying and selling = 3.34%

Well, 3.05% net gain isn't that bad. But wait… we haven't factored in the brokerage plus commission costs yet. If we are paying $10 flat-fee per trade, there is another $300 that needs to be deducted from our net. Our winnings of $3,195 are now reduced further to $1,225 - or a 2.45% gain - which is 40% less than the theoretical performance stats listed on the stock picking site.

As well, we may have encountered far higher slippage than that. And there is one aspect we never considered - even if we could achieve the 49% annual growth rate, could we really compound this into almost 400 million with this particular strategy? This would be highly unlikely since the more money you have, the harder it is to invest without driving prices sky-high. Just look at the problem Warren Buffett has - he needs to buy during high volume sell-offs and in larger companies. Even still he is struggling to find enough opportunity to invest the massive amounts of capital at his disposal. The more money you have the more liquid companies you need to invest in.

Chart: Possible Slippage Plus Commission Costs (Percentage) Based on Liquidity and Skill

So just how can we reduce the effect of active trading and what is a reasonable expectation to have?

Reducing the High Cost of Active Trading

Tip#1: Perhaps the most important tip for small or new active investors is to use limit orders. A limit order is where you buy or sell with a limit as to the maximum buying or minimum selling price. Why is this so important?

On smaller capitalization stocks with low liquidity there will often be a wider bid/ask spread. In larger stocks you may see a small difference of one or two pennies between the price buyers want and what sellers are willing to offer. On these smaller stocks you may see large spreads making up 5% of the share price or more. Simply buying the asking price could instantly put you in a losing disposition. What can you do?

According to the average gain in the strategy you are using, pre-determine the maximum amount of slippage loss you are willing to accept. Make that the upper threshold of your limit order. If you are willing to accept a 0.5% slippage on a $10 stock, then you need to place your limit 5 cents above the $10 bid. Is this a high earnings small-cap strategy with larger spreads and you are willing to accept 1.5% slippage? Then place your limit buy order at $10.15 with the stock that has a $10 bid. Remember that there is no guarantee you will get your order filled even anytime soon and you may need to keep raising the limit order until you strike a balance of getting 75% or more of your order filled at an acceptable price.

Tip #2: If your buy orders are excessively large for the stock you are trading, you may want to break it up into smaller trades made at regular intervals over the day.

This is a trick used by institutional traders who actively manage their trades instead of using limit orders. By breaking up a bigger trade into smaller bite-sized transactions, there should be a more smoothed out average entry price with fewer opportunist traders taking advantage of you. That is the theory anyway and they often use volume weighted moving averages to determine if the strategy worked or not.

Tip #3: Get your brokerage costs down. One option is to use a commission free brokerage, but this may not be your best bet with stocks of low liquidity. Why? Because when using their (the un-named company) patented 'window trading' system, you have no control over what a good entry price is. While you might be happy with unlimited trading in a month for $29 where the brokerage makes the trades for you over a window of a few hours in liquid stocks - the risk of market impact in illiquid stocks is too high to delegate to your broker. They also offer $3 flat-free limit orders when trading stocks of lower liquidity.

Another option to keep broker pricing down is to go with a 'per-share' cost structure. Half a penny per share (flat rate pricing on US markets) would make buying 500 shares cost $2.50. They un-named company also have a Cost Plus plan for direct market access where you earn trading credits if the buy limit order is less than the asking price or if the sell limit order is more than the bid. If all of your trades are as described in the previous sentence, you should actually earn a small profit per trade outside of any share price gain.

Coming Full Circle

So what does all this mean as to bottom line profit? While there are some robust trading strategies for active investors, you cannot ignore the mechanics and practice of trading in the hopes that a good stock pick will trump all else.

Your first consideration should be to examine the average liquidity of the stocks you are trading. Is there a small or a large bid/ask spread? Also look to the depth of liquidity… how many shares are available for purchase just above the bid, and the next tier above that? There might be a tight bid/ask spread with 100 shares but what impact will buying 10,000 shares have? Limit orders will go a long way to lower liquidity risk with sound trade management.

Work to keep your brokerage fees down by analyzing your average shares per stock traded. If you typically trade 600 shares or less per security, you may experience a strong advantage by using a 'per share' brokerage with low fees. If you trade more than 600 shares on average, finding a deep discount brokerage with $3 - $4 per trade 'all in' might be a better option.

If you are struggling with getting your orders filled, or consistently get them filled at unfavorable prices - you may need to trade stocks of higher liquidity.

After it is all said and done, a small-cap strategy that has consistently generated 4% every month might only yield 2 - 2.5% monthly after all brokerage fees are taken into consideration and assuming you have a measure of skill in executing limit orders. And this amount is not liable to be perpetually compounded from $1 into $1 billion - once your capital outgrows the strategy you will need to complement it with other strategies in order to experience any kind of compounding effect.

Does this mean that small-cap strategies are not worth the effort? Hardly. But trade with both eyes open knowing the limitations of the strategy and modestly acknowledging your own weaknesses to avoid being surprised when the net gain is less than the theoretical gain posted on a stock picking site.

Source: The Many Hidden Costs Of Active Investing In Small Caps