Is it safe to assume that the trading fees of discount brokerage firms are too small for concern? Maybe, when the investment is large enough to effectively offset the fees. But beware that capital gains from small investments are diluted by trading fees. When does the investment incur a large penalty? It depends on the following factors.
Realized capital gains
Trading fees penalize the capital gains of small investments. Two ways of reducing this penalty are to 1) seek low trading fees, and 2) trade with large amounts of cash. These are illustrated in the following charts:
Chart 1 compares two levels of investment (A versus B) in the same equity security that differ by the volume of equity shares. The larger volume at same share price causes level B’s principal ($5,000) to be 10 times larger than level A’s ($500). The brokerage fee causes level B’s cost basis ($5,010) to be 9.82 times greater than level A’s ($510).
In chart 2, the desired rate-of-return represents an arbitrary investment goal. Holdings A and B are sold at $110 per share based on the desired 10% increase above purchase price. Again, the principals are proportionately different by a factor of 10 and the total proceeds are disproportionately different by a factor of 10.17.
Chart 3 illustrates the advantages of 1) paying a lower brokerage fee and 2) trading with a larger cost basis. Without the brokerage fee, the “cost-free” capital gain increases according to the difference in share prices at the time of purchase and sale. With the brokerage fee, the total cost of trading reduces the realized capital gain. Investment A’s 5.88% rate-of-return is disproportionately lower than investment B’s 9.58% rate-of-return. Investment A’s lower rate-of-return reflects a higher margin (“penalty margin”) below the desired rate-of-return.
Reset share price (“sell signal”)
The core message of chart 3 is that trading fees prevent the realized gain from reaching its full potential. The full potential might be achieved by resetting the sales price to a higher value based on inflating the cost basis. The inflation rate declines as the cost basis increases. Chart 4 shows that the reset share price is lower in investment B due to B’s higher cost basis. The reset share price is a useful sell signal.
Beware of the penalty margin
The penalty margin is graphically illustrated (below) by the vertical distance between the red line for cost-free gain and blue line for realized gain. The penalty margin is unacceptably high when the investment (i.e., cost basis) is very small. The following link, potential capital gain, provides a calculator for estimating investments that have a low penalty margin and high potential capital gain.
copyright © 2012 Douglas R. Knight