Trading Rule – “Never ignore the impact of trading costs”

IF YOU ARE A TRADER IN THE STOCK MARKETS THEN TRADING COST IS AN EXTREMELY IMPORTANT FACTOR DETERMINING THE ECONOMICS OF THE TRANSACTION! WHEN WE TALK OF TRADING COSTS THERE ARE VISIBLE COSTS AND INVISIBLE COSTS. THE VISIBLE COSTS INCLUDE THE BROKERAGE, STT, GST, STATUTORY CHARGES, STAMP DUTY ETC. THERE ARE INVISIBLE COSTS LIKE LIQUIDITY PREMIUM, COST OF BID-ASK SPREADS, COST OF DELAYS IN EXECUTION ETC. IF YOU ARE A TRADER THEN YOUR FOCUS MUST BE TO KEEP ALL THESE COST AT THE BARE MINIMUM TO KEEP YOUR TRADE MEANINGFUL

WHY TRADING COSTS MATTER FOR A TRADER?

There are 3 reasons why the trading costs matter to a trader. Firstly, when you are a trader your trade is all about a risk-return trade-off. You typically trade with a risk-return trade-off of 2:1 or at best 3:1. Higher visible and invisible costs can make a huge difference. Secondly, the idea of trading is to churn your capital as aggressively as possible and therefore there will be costs on both sides. Over a period of time these costs can add up to quite a bit and negatively impact the economics of your trading. Lastly, the impact of trading costs is much bigger than you may care to imagine. Consider that you are trading in Reliance Industries which is priced at around Rs.950. A total trading cost of 0.5% means that your break even is Rs.5 and if the total trading cost is 1% then your breakeven is Rs.10. When you are trading for the very short term this makes a huge difference! That is why your focus as a trader must be on keeping your trading costs as low as possible.

AS A TRADER YOU MUST ALSO FOCUS ON THE INVISIBLE COSTS

Most traders do not give due consideration to the invisible costs and that can actually be more significant to your profitability than the visible costs. Firstly, if you trade in illiquid counters, you are paying a premium each time you are buying and giving a discount each time you are selling. If you put a monetary value to this cost, then it can be quite big. Secondly, there are costs in terms of the leverage and leeway that your broker allows you. As a trader, you want to get the maximum leverage that is possible so that you can actually trade in a multiple of your capital. Also you need to ensure that your broker credits the proceeds of sales and the demat purchases on time so that there is no time value loss for you. Lastly, there is also the cost of poor quality of advice by the broker. To get the best of your trading you either need a broker to give you good quality calls or empower you to trade with tools. Quality research and ideas go a long way in empowering you to trade profitably and your focus must be on a broker who can reduce the cost of poor trades.

“Don’t worry about what the markets are going to do. Worry about what you are going to do in response to the markets” – Michael Carr

6 TYPES OF TRADING COSTS THAT CAN BECOME A REAL PROBLEM

  1. First, is the plain brokerage cost! There are discount brokers and there are full-service brokers. Choose your broker based on the cost you are willing to bear and the services you expect from your broker. If you are a compulsive self trader then the best you can do is to opt for a discount broker who will give you the least possible brokerage. These brokers will not give you any exciting research ideas but that is anyways not what you are expecting. Keep your brokerage costs at the bare minimum.
  2. Second, is the cost of overtrading! All trading must be done with a distinct purpose. The whole idea of trading aggressively to recover your losses is a bad idea. You only end up getting into sub-optimal trades and adding to your cost of trading without improving your performance. When you overtrading, your capital is being churned, your costs are adding up and your performance is suffering. This is a big cost for traders.
  3. Third, is the cost of liquidity in the markets! Most traders do not sufficiently appreciate this point but ensuring that you do not pay too much in terms of inappropriate spreads is important. The more you trade in second rung stocks with weak liquidity the more you are exposing yourself to liquidity costs. This cost is lower in frontline index stocks.
  4. Fourth is the cost of poor execution. Don’t blame this on the broker, because more often than not poor execution is your doing. When you place a market order in a rising market it is a case of poor execution. When you place a limit order in a sharply falling order it is again a case of poor execution. We normally do not measure it but bad execution imposes a big cost on your trading performance.
  5. Fifth is the cost of inadequate preparation in the market. This takes various forms. You may be fully invested when the market has fallen or you may be sitting on cash when the markets are trending up. This has a huge cost. You may also pay the price of not doing your homework before trading, not reading up the company news and financials and end up with a bad trade. Spend time; even traders need to do their homework.
  6. Lastly, there is the cost of not taking losses on time. Smart trading is all about cutting your losses fast and running your profits longer. Hope is a good breakfast but a bad supper. When you end the day with hope then you could be in for a nasty surprise next day. Learnt to take losses as holding on can be awfully expensive at times.

CREATE A SPREADSHEET OF VISIBLE AND INVISIBLE TRADING COSTS

Do a sensitivity analysis of how a reduction of any of these factors can make a difference to your trading profits. That will put a lot of things in perspective. The bottom-line is that as a trader you must keep your visible and invisible costs under a tight leash!

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