Commissions and Taxes Are Destroying Your Trading Profits
Eighteen thousand three hundred and sixty-four dollars.
That was the total cost of commissions I paid to Scottrade when I just started trading.
My trading account was around twenty-five thousand.
- $25,000 trading account.
- $18,364 commission cost.
I needed to make a 73% return just to break even.
I ended up losing around three thousand dollars that year and the only thing I was focused on was improving my trading skills.
I had to get better.
I had to work on my strategy.
I had to build up the proper trading mindset.
This is what the books and literature told me I needed to do if I wanted to turn a profit.
I was a young trader at the time and I didn’t know any better.
I was stuck in a situation that stacked the odds so laughably against me, it was virtually impossible to turn a profit with the path I was on.
I was actively day trading stocks and options with an expensive broker.
I made over 60% return that year! I did damn good.
In hindsight, most of those returns were attributed to getting lucky and taking vomit-inducing outsized risks, but the truth is, it could have been a lot worse.
It wasn’t long after reading through my 1099 around tax time when I realized it was time to divorce Scottrade and search for a broker that would treat me better.
I’ve recorded this lesson in video format, so if you’d rather sit back and listen, click play on the following YouTube video.
The most overlooked but expensive cost for traders are commissions
I was recently consulting with a new trader who was explaining a near identical situation to the one I lived through years ago:
- Looking to actively day trade
- Paying $7.95 per trade
- Account under 20K
It’s a boring conversation for most traders, especially if you’re just starting out.
But these innocent sounding commission costs add up and the earlier you can get them under control, the better.
Let’s run through a hypothetical example to illustrate the impact of commissions.
Meet Johnny the day trader.
Johnny is new to the stock market and really looking forward to growing his account fast.
Let’s assume Johnny’s situation is as follows:
- He makes 10 trades per week (that’s 20 transactions, buy and sell).
- He takes partial exits on half of his trades (extra 5 transactions).
- He pays his broker $5.95 per transaction.
- Johnny takes 2 weeks of vacation per year with no trading.
Here’s how the math breaks down given those stats:
- 25 weekly transactions X 50 Weeks = 1,250 annual transactions.
- 1,250 total transactions X $5.95 = $7,437 out of pocket to the broker.
So now the question becomes, is that reasonable?
It very well might be if he is trading a healthy six-figure account.
Let’s see what kind of returns Johnny would need to break even on $7,437 in commissions.
|Starting account size||Return required to break even|
Even a $100,000 account requires a 7% return just to break even.
That’s roughly the long-term annual growth rate of the S&P500!
Except, it’s not growth, this transaction tax is negatively compounding against Johnny’s account year after year eating away at his hard-earned trading profits.
The good news? The solution is simple.
Get more profitable immediately by reducing your commission costs
There’s no other trading cost that comes remotely close to commissions for traders.
So what should you do?
Find a cheaper broker!
The good news is the year over year costs of commissions are in a long-term bear market and in 2019 most brokers went completely free!
A big thank you to Robinhood (use that link to get a free share of stock) for helping set a new industry standard way ahead of everyone else. In 2014 the mobile first broker Robinhood launched with $0 commissions setting the expectation that trading stocks ought to be free. It took 5 years, but finally in 2019, the majority of retail brokers capitulated and dropped their commission fees down to $0 as well.
Given all of the zero cost brokers to choose from, the advice is simple.
Whether you are paying $7.95, $5.95, or $2.95 per trade, review closely the benefits your broker is providing you and think hard about how much a cheaper alternative could boost your bottom line profitability.
And to be clear, this is primarily written for the active traders. If you’re a position trader that makes a dozen trades per year, paying $9.95, and you’re happy and comfortable with your platform and broker then by all means stay!
Your costs are trivial.
Also, if your broker is providing you real benefits like: better fills, access to tools, technology, or APIs, support, or anything else that is helping you make money, then paying commissions might be justified for your situation.
Get more profitable immediately by trading in tax-deferred accounts
Taxes play a potentially even greater role in eroding your trading account over time.
It’s tricky to speak specifically on taxes because everyone reading this is from different countries, income brackets, ages, etc. but we’ll share some high-level thoughts for you to think about.
As a reminder nothing published on The Trade Risk is financial advice, nor is it tax advice, so please consult a CPA and review our site disclaimer.
First off, let’s define tax-deferred savings:
Tax-deferred savings occurs when you use a specially designated account, or investment option, that does not require you to claim the investment income earned inside of the account every year on your tax return. Instead, you get to defer this investment income until you choose to take a withdrawal from the tax-deferred savings account or until you cash in the investment. – theBalance.com
Tax-deferred accounts generally fall under the category of retirement accounts, which means, there are some extra strings attached in terms of contribution limits and early withdrawal penalties.
You can’t simply flip a switch and move all of your capital into a tax-deferred account and then move it back out as you please.
But the growth over time benefits of allocating into tax-deferred accounts can be tremendous. Let’s look at an overly simplified version of growth between taxable and tax-deferred accounts.
15% annual growth with a 30% taxable rate
Returns would never be this linear in the real world but I think the underlying point is well illustrated. Losing upwards of 30% (or more) of your gains due to taxable income each and every year is extremely costly over the long haul.
Self-directed IRAs are the most flexible and easily accessible structure for tax-deferred investing. You are free to trade individual stocks, and can even participate on the short side for hedging or directional bets using inverse ETFs.
I love running my active swing-trading strategy in my IRA and not needing to worry about paying Uncle Sam come tax time at the end of the year.
The downside, of course, is that once you contribute money to these types of accounts, it’s stuck there. If you’re trading stocks in order to supplement your income and pay for the electric bill then investing purely in IRA-type structures will not be for you.
Ultimately, it comes down to your goals.
There’s no doubt you will keep more of your earnings when trading in tax-deferred accounts, however, if you are trying to save up for a new car or washing machine, then it’s probably not going to be the best structure for you.
If long-term capital growth is your goal, then drop everything and start cramming as much cash as you can into deferred accounts!
Commissions and taxes are destroying your trading profits
Beating the market as an active investor is difficult enough over the long haul.
Don’t make your life any harder than it has to be.
Get your commission costs under control and be strategic with the structures in which you invest your capital.
Chances are the 200 hours of research you’re going to put in optimizing your entries and exits won’t outweigh the 1 hour it takes to solve for commissions and taxes.
If you’ve found this article helpful I encourage you to take a look at our learning center which has dozens more just like this on all things trading.
Thanks for reading and good luck out there.
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