Two Major Hidden Brokerage Costs
Two Major Hidden Brokerage Costs
By
William Cate
Few Small Capital Investors realize that they are paying multiple fees when they buy or sell stock. Nor do they realize that there are major cost differences between trading shares on traditional stock exchanges like AMEX, NYSE, PSE etc and trading shares on the National Association of Securities Dealers (NASD) Nasdaq and the Over-the-Counter Bulletin Board. Those undisclosed costs often make the difference between profit and loss for investors.
Most investors believe that the only cost they pay to trade stock is the brokerage commission. If the investor is wise, they use a wirehouse (online brokerage service) and often pay less than ten dollars per trade. This is a huge saving over the 3.25% charged per trade by many traditional brokerage firms.
The NASD spread makes it nearly impossible for many investors to profit from the Market. Essentially, the spread is the difference between the wholesale and retail price of any stock that trades on Nasdaq, the Over-the-Counter Bulletin Board (OTCBB) or the Over-the-Counter Market (Pink Sheets). For a high-trading volume Nasdaq stock, it is often about 1%. For a rarely trade, Pink Sheeted stock, it can be 300-500%.
Let's assume that you want to buy an OTCBB stock. The spread is 10%. This means the selling broker will add 10% to the price that his or her client wants for the stock. If the buyer wants to sell at $3/share, the Ask will be $3.30/share. Your wirehouse buys at $3.30/share and the selling broker makes a 10% spread. If you purchased a "hot stock" that is being heavily promoted, it will move up. You may want to sell your shares when the share price hits $5.00. Your broker will Ask $5.50/share and some buyer will take you out of the stock paying another 10% spread. Assuming you paid $10 to a wirehouse for each trade and you purchased 1,000 shares of the OTCBB stock, your total brokerage costs weren't $20.00. They were $820 ($20 + $300 +$500).
You don't own the shares that you buy. The registered owner for over 99% of the shares that trade on all U.S. Markets is Cede & Company. When you buy stock, you own an option on the shares against your brokerage firm. If your brokerage firm isn't among the major 300 banks and brokerage firms that form the Depository Trust, your brokerage firm holds an option against one of these "Participants." Thus, many Small Capital Investors hold an option on an option against the shares they purchase. This structure is intended to make the T=3 trading system work by having Cede & Company as the owner of everyone's shares.
Share prices are a function of supply and demand. When the demand for the shares is greater than the supply, the share price goes up. When the supply exceeds the demand, the share price goes down. There are two things that increase the supply of any stock. They are Insider selling and short selling.
It's the short selling that the Cede & Company solutions facilitate. Any buyer of the stock would be crazy to lend their shares so that the share price can decline. However, Cede & Company makes its money by creating a pool of shares that can be used by short sellers in at least two dozen ways to increase the supply of shares in the float (stock held by the public) and thus create a strong downward force on the share price.
Let's assume that you buy your 1,000 shares for $3.30/share. Your purchase and that of other buyers are met by sales by short sellers. The company's float is two million shares. The short sales add a million shares to the float. If the demand for the shares remains constant, the share price will drop to $2.10/share and you have lost one-third of your money.
I've never seen a stock without a large short position. Often, the short position is well hidden. In many cases the short sellers have dumped more shares than the company has issued. If you assume the average short position is one million shares at an average short sale price of $3.00, the company's shareholders have paid $3,000,000 in hidden costs above and beyond any fees directly charged by the brokerage houses.
A public company can stop this loss by not allowing its insiders to sell their shares and by going to a Cash Market for its float. Market decisions that are definitely contrary to current practices but would be very beneficial to the company's public shareholders.
If you think things are bad for Small Capital Investors, they are far worse for mutual fund buyers. Costs kill public investors. Ask your brokerage firm and the companies in which you own or intend to buy shares how they manage to control brokerage costs.
By
William Cate
Few Small Capital Investors realize that they are paying multiple fees when they buy or sell stock. Nor do they realize that there are major cost differences between trading shares on traditional stock exchanges like AMEX, NYSE, PSE etc and trading shares on the National Association of Securities Dealers (NASD) Nasdaq and the Over-the-Counter Bulletin Board. Those undisclosed costs often make the difference between profit and loss for investors.
Most investors believe that the only cost they pay to trade stock is the brokerage commission. If the investor is wise, they use a wirehouse (online brokerage service) and often pay less than ten dollars per trade. This is a huge saving over the 3.25% charged per trade by many traditional brokerage firms.
The NASD spread makes it nearly impossible for many investors to profit from the Market. Essentially, the spread is the difference between the wholesale and retail price of any stock that trades on Nasdaq, the Over-the-Counter Bulletin Board (OTCBB) or the Over-the-Counter Market (Pink Sheets). For a high-trading volume Nasdaq stock, it is often about 1%. For a rarely trade, Pink Sheeted stock, it can be 300-500%.
Let's assume that you want to buy an OTCBB stock. The spread is 10%. This means the selling broker will add 10% to the price that his or her client wants for the stock. If the buyer wants to sell at $3/share, the Ask will be $3.30/share. Your wirehouse buys at $3.30/share and the selling broker makes a 10% spread. If you purchased a "hot stock" that is being heavily promoted, it will move up. You may want to sell your shares when the share price hits $5.00. Your broker will Ask $5.50/share and some buyer will take you out of the stock paying another 10% spread. Assuming you paid $10 to a wirehouse for each trade and you purchased 1,000 shares of the OTCBB stock, your total brokerage costs weren't $20.00. They were $820 ($20 + $300 +$500).
You don't own the shares that you buy. The registered owner for over 99% of the shares that trade on all U.S. Markets is Cede & Company. When you buy stock, you own an option on the shares against your brokerage firm. If your brokerage firm isn't among the major 300 banks and brokerage firms that form the Depository Trust, your brokerage firm holds an option against one of these "Participants." Thus, many Small Capital Investors hold an option on an option against the shares they purchase. This structure is intended to make the T=3 trading system work by having Cede & Company as the owner of everyone's shares.
Share prices are a function of supply and demand. When the demand for the shares is greater than the supply, the share price goes up. When the supply exceeds the demand, the share price goes down. There are two things that increase the supply of any stock. They are Insider selling and short selling.
It's the short selling that the Cede & Company solutions facilitate. Any buyer of the stock would be crazy to lend their shares so that the share price can decline. However, Cede & Company makes its money by creating a pool of shares that can be used by short sellers in at least two dozen ways to increase the supply of shares in the float (stock held by the public) and thus create a strong downward force on the share price.
Let's assume that you buy your 1,000 shares for $3.30/share. Your purchase and that of other buyers are met by sales by short sellers. The company's float is two million shares. The short sales add a million shares to the float. If the demand for the shares remains constant, the share price will drop to $2.10/share and you have lost one-third of your money.
I've never seen a stock without a large short position. Often, the short position is well hidden. In many cases the short sellers have dumped more shares than the company has issued. If you assume the average short position is one million shares at an average short sale price of $3.00, the company's shareholders have paid $3,000,000 in hidden costs above and beyond any fees directly charged by the brokerage houses.
A public company can stop this loss by not allowing its insiders to sell their shares and by going to a Cash Market for its float. Market decisions that are definitely contrary to current practices but would be very beneficial to the company's public shareholders.
If you think things are bad for Small Capital Investors, they are far worse for mutual fund buyers. Costs kill public investors. Ask your brokerage firm and the companies in which you own or intend to buy shares how they manage to control brokerage costs.
