The Hidden Cost of Stock Trading

When you buy and sell stocks on the open market, you make trades through your broker by way of agents who specialize in the particular security in question. Buyers and sellers of stocks are not matched one-for-one at the market price. Rather, these market makers will sell you a stock at the "ask" price or buy your stock from you at the "bid" price. The spread is the difference between the bid and asked price on a stock.

The spread is part of the broker's profit. Dealers make their living by "taking the spread" on each transaction. This is their fee for making the market and keeping the market "liquid". That is, they will always have quantities of the stock to trade because they trade in such great volume.

The Spread is Larger on the NASDAQ

Because the spread represents the "cost" of maintaining inventory, it stands to reason that the more heavily traded a stock is, the smaller the spread, since less inventory is needed.

This is why the spread tends to be larger on the NASDAQ because NASDAQ shares are typically much less heavily traded than those on the NYSE or AMEX. Couple this with the lower average per share price on the NASDAQ and you have a real cost issue. If you buy a stock at $5 with a 50 cents spread, the price will have to go up by 10% just for you to break even!

There is a Spread on the New York Stock Exchange, Too

It is a popular misconception that the NYSE does not have spreads. It does. The mistake stems from the NYSE rule that prohibits the spread from being published by delayed quote services (like the next day's Wall Street Journal). However, any good Real Time Quote service will display the spreads. For the NYSE, the spread is typically 1/8 to 1/4. This compares favorably to the average NASDAQ spread of 1/4 to 1/2 .

On-Line Trading - Are you really paying less?

With on line trades going for as little as $10 per trade, the answer to your question: "How can they do it?" is that they profit from the spreads. While technology and interest rates have some impact on online brokerage profits, the chief source of their income, besides your per trade fee, is through a sharing of the spread with the market makers.

As online brokers increase their volume, they can appeal to the market makers for a share of the spread in exchange for increased business-which the market makers gladly do. And while the practice does smack of "kickbacks" it is perfectly legal. But some times it costs you more, because the spread is increased.

As a result, you may want to think twice about how much you are saving by using an online broker, especially for low priced, NASDAQ shares. Try a discount broker that uses Instinet or other similar trading services. You may pay more per trade but less per share, and get more per share when you sell.

Instinet-like services allow brokers to transact directly with other brokers and institutions to bypass the market makers. The system allows them to access so called "Level 2" quotes, to see the best bid and ask offers and to execute closer to them than otherwise possible.

It may well be worth the extra per trade commission to get the better price. On a 100 share transaction, a 1/4 difference amounts to $25, a 1/2 differential to $50. You can see how quickly a $10 online commission can cost you $35-60 in actuality. And for a 1000 share transaction, there is no contest!

Limit Orders Also Help

You can also hedge the cost of spreads by using the limit order. Instead of instructing your broker to buy at market, give a specific price limit for the transaction. By this method, you can cut the spread if the price moves in your direction or if the broker or market maker is willing to take less.

Say the shares you want to buy are at "10 bid, 11 ask". If you limit order at 10 1/2 you may catch a break if the market maker accepts your offer; or if in the meantime the price falls to "9 1/2 bid, 10 1/2" asked. If not, you will not have the trade.

The limit order is a good tool, but it too has its limits. Some online brokers charge you extra for this service. Ameritrade, Quick & Reilly; National Discount Brokerage and E Trade all charge $5 per trade for limit orders. Fidelity charge $3. Datek, Waterhouse and Charles Schwab do not charge for limit orders, but do charge a higher commission, if you place a limit order.

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