I recently had a conversation with a younger client that had me reflecting upon platforms that offer commission-free trading. The client was considering opening a self-directed brokerage account.  I was encouraging. After all, I fell in love with markets as a teenager, and I made many mistakes and learned many valuable lessons that I leverage to this day.

 

Times have changed

 

When I started trading, one advantage that I had over someone starting out today was the high trading fees that I had to navigate.  That is going to sound counterintuitive to investors who can trade for ‘free’ today, but when I started investing in stocks, I had to pay about $150 to buy or sell a stock.  These trading fees were quite large relative to the amount of money (capital) that I had available to invest. I quickly learned that if I traded frequently, commissions would eat up both my profits and capital.  As a result, I had to be very selective and informed before I invested because the cost of opening and closing a trade was so large relative to my capital.

 

Today, a new investor does not benefit from those same constraints that forced me to learn about investing and my investments.  On many platforms, a new investor is greeted an interface that looks like a video game, and is immediately given access to sophisticated tools like margin loans and option trading.

 

The hidden cost of ‘free’ trades

 

A new investor also needs to be aware of hidden and frictional costs associated with their stock trades: 

• Tax reporting is an item that many new investors fail to appreciate. 
  • If you trade often, preparing your tax return could become very time consuming or expensive (if you pay a professional to prepare your taxes).  The article What Robinhood Traders Need to Know About Taxes from the WSJ, highlights the surprise experienced by a new stock market participant when the first of his tax packages arrived. It was 34-pages long and the $8,000 trading profit highlighted in the article, is unlikely to cover the cost of preparing a tax return that must documents approximately 12,000 trades (=200 trades per day x 120 days or six months / 2).  
  • If you trade often, the Canadian government may classify you as an active trader, and your profits will be subjected to income tax rules (which can reach 53.53% in Ontario) and not capital gains rules (which can reach 26.8% in Ontario).  Once you are classified as an active trader, it is not easy to be re-classified as a regular investor.
• There is a psychological cost to trading, especially in volatile markets or volatile securities. If you are getting distracted by your positions during the day (regardless if they are moving up or down), the positions are too large and should be reduced until they no longer distract you.

Some cautious statements for new investors:

• The stock market is a zero-sum game, so to make money, you are taking it from other market participants.  When you buy a stock it is because another investor is willing to sell you the stock at the price you offered to pay.  The opposite is true if you are selling a stock.  I would encourage new investors to envision whom they are trading ‘against.’
• If you are taking concentrated positions in speculative securities, you should be aware that you can quickly lose money.  Many professional investors will use volatility as input when sizing their positions – the more volatile the security, the smaller the relative size of the position in a portfolio.
• Speculating using options and margin loans will magnify your profits and your losses. Both should be avoided by investors who do not have a strong understanding of how these securities and systems function. Using option and margin loans an investor may quickly find themselves in a situation where they have lost significantly more money than they invested or even knew they had at risk.

If you are not paying for a product …

If you are not paying for a product, you are the product.  This is lost on many people who are new to the market a pursuing a DIY (Do It Yourself) approach.  Many DIYers do not realize that their free-trading platform makes money by:

• selling their trades to brokerages to execute,
• lending the securities investors hold in their accounts to short sellers, and
• loaning DIYers money that they can invest (called margin loans).  

While the marketing spin is that these platforms are democratizing investing, DIYers should realize these platforms are profit seeking entities and are acting in their own best interest. While I’ll rarely cite content from the website Zero Hedge, the article Exposing The Robinhood Scam: Here’s How Much Citadel Paid To Robinhood To Buy Your Orders helps explain the business model.  If you are considering a commission free trading platform, you should be aware that their customers are large brokerages owned by asset managers, and the slick trading interface is how they manufacture their product (your trades).

 

Let me know if you would like to have a more detailed discussion.

 

Delli (Delli@cibc.com)

 

Disclaimers:

• Clients are advised to seek advice regarding their particular circumstances from their personal tax and legal advisors.
• This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers, and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory services, investment banking or other services for, or have lending or other credit relationships with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and a spread between the bid and ask prices if you purchase, sell, or hold the securities referred to above. © CIBC World Markets Inc. 2021.