I’ve been a commodity broker since 2003. Throughout that time we’ve seen massive shifts in the manner retail traders execute orders in the futures and options markets, but more importantly we’ve seen transaction costs plummet due to massive improvements in execution efficiency.
Generally speaking, technology and easy market access has been a giant step in the right direction to leveling the playing field for the average futures market speculator. However, I believe the pendulum has swung a little too far. I argue that overly competitive commission rates have caused brokers to cut corners that shouldn’t be cut. The result is, in my opinion, decreased odds of trading success for the average retail trader.
Transaction Costs are Low, but are they too Low?
Commodity brokers in the 1980s will tell you they enjoyed round turn commissions in the $50 to $100 range; fast forward to the 2010s and brokers are charging well under $10 for online trading. This has been a fabulous transformation for retail traders, but there is such a thing as too much of a good thing. As futures brokerage commissions get cheaper, the service and trading support gets worse.
In fact, I argue that this environment encourages green commodity futures and options traders to participate in the markets without the proper assistance they need; and higher lot sizes than they should (low transaction costs encourage over-trading). In addition, experienced traders who are normally highly self-sufficient are sometimes finding themselves in a precarious position due to the inadequacy of their brokerage firm. If you are new to commodity trading, you might not understand this but if you’ve traded through a calamity such as the 2010 flash crash, the August 2011 debt crisis, or even the August 2015 China collapse, you’ve probably discovered that your brokerage firm has the potential to play a big part in determining trading success of failure.
Where are discount brokers cutting corners?
Without “the float” acting as a subsidy to revenue and commission rates in the gutter, brokerage firms are far more exposed to economic cycles and industry risk than they once were. Once again, the result is cost and risk cutting in regard to their brokerage clients. After all, when dealing with dismal profit margins it is not realistic to allocate resources to support brokerage clients.
Imagine the angst you might feel if your trading platform malfunctions while you have a large position open, and you can’t get your brokerage firm on the line to correct it. Or the frustration of having your futures or options position force liquidated near the lows of a “flash crash” despite your account having plenty of margin on deposit, only to watch the market recover without you. These are real examples, and in many cases the unnecessary trading losses suffered at the hands of an inefficient brokerage service can amount to thousands of dollars. In the end, the pennies saved on commission might not mean anything relative to the damage to the trading account.
Many discount futures and options brokers are charging commission rates so low that their potential profit margin is a few of pennies per trade. Accordingly, they cannot afford to accept any client trading risk (remember, futures and options traders can potentially lose more money than they have on deposit). The result, is a heavy handed and overly quick risk manager and frequent force-liquidation of brokerage client positions. This can be a very expensive experience for a trader, particularly an option trader, because a risk manager liquidating positions typically places market orders without regards to price and time. During times of high volatility, such as the mini crash that took place in late August of 2015, inopportune and involuntary position liquidation might be the type of devastation a trading account can’t recover from.
Limit Strategy or Products
Skimpy profit margins at commodity brokerage firms have led many to reduce the products and trading strategies clients are allowed to trade. For instance, few brokers give their clients the green light to sell naked options, and some even prohibit limited risk option spread trading. Further, brokers often set their platforms to reject futures orders in contracts in any expiration month other than the most liquid front month, and in other cases brokers restrict access to many of the commodity markets by only enabling trading in a handful of the most popular futures contracts. In my opinion, this is unacceptable and even ruthless. Option strategies offer traders risk management solutions and, in many cases, higher probability strategies relative to outright futures trading. In addition, trading back month commodity contracts are often helpful in spreading risk exposure. In other words, perhaps these brokerage firms’ actions to reduce their own risk has directly increased the risk their clients are exposed to.
How did we get here?
Commodity brokers have been in a commission war for years; in effect, many insiders describe the current state of the future industry as cannibalism. As industry transaction costs have dwindled they have been forced to find ways to cut costs. As a result, there are far less trade desk clerks, tech support team members, customer service reps, etc. to service client accounts. Naturally, fewer people to service the same number of accounts, or arguably more accounts, results in a decline in effective service. Eventually, a skimpy support staff will lead to expensive mishaps, usually suffered by brokerage clients.
Adding fuel to the fire of the commission war has been the Federal Reserve’s persistently low interest rate policy. Prior to this era of near zero interest rates, commodity brokerage firms generated a substantial amount of revenue from what they refer to as “the float”. The float is simply the interest earned on the margin deposits of their clients. Simply put, if a client deposits $100,000 into their futures trading account to be used toward the margin, their brokerage firm is earning interest from a bank on that deposit. In today’s world, it is very little but when I entered the business in the early 2000’s it was roughly 5% annually and amounted to a substantial revenue stream for brokerage houses.
Sometimes Cheap is Really Expensive
Sometimes it is difficult to measure the intangible expenses and benefits that come with choosing the right futures broker for your circumstances, but it is easy to see transaction costs. After all, every penny paid to your broker, to the exchange in clearing fees, and the NFA in its transaction fee, are detailed on a trading account statement. Nevertheless, if you choose a brokerage firm based on commission alone, and you find they are dictating which products you trade, how you trade them, and in volatile markets when you exit them, you are essentially tripping over dollars to chase pennies.
If you think commission is expensive, try getting what you pay for. The odds favor that your hidden expenses will far outweigh the visible ones.
*There is substantial risk of loss in trading futures and options. There is unlimited risk in option selling!
Carley Garner is the Senior Strategist for DeCarley Trading, a division of Zaner, where she also works as a broker. She authors widely distributed e-newsletters; for your free subscription visit www.DeCarleyTrading.com. Her books, “A Trader’s First Book on Commodities,” “Currency Trading in the FOREX and Futures Markets,” and “Commodity Options,” were published by FT Press.