Options Commissions and Other Trading Costs

Execution costs are an important consideration for traders in any market. Commissions, exchange fees, bid/ask spread and capital charges impact every trade we make, cutting into the bottom line on winners and compounding losses on trades that don't work out as planned. Whether you run a billion dollar hedge fund, or a thousand dollar personal account, understanding and minimizing trading costs is one of the fastest ways to improve results and ensure that your capital is employed most efficiently in pursuit of your trading goals.

Commissions are the easiest place to start when it comes to cost control. Today's market features a diverse field of broker-dealers that provide a wide range of services and technology to meet the needs of many different types of traders. Commission rates vary widely, and higher rates do not always equate to better value. For typical active retail traders, intense competition in the online brokerage business has led to option commissions well below $1.00 per contract at some of the largest e-brokers. A sliding scale for high levels of monthly contract volume and additional discounts for contracts priced under a dime can get rates down to a quarter per contract in some cases. In addition, some brokers now waive commissions entirely for clients closing short option positions for a nickel or less as a gesture to promote responsible risk reduction. Shop around and look for a commission schedule that matches your trading style. Small lot traders should watch out for minimum ticket charges, and additional hidden costs for things like assignments and monthly market-data fees. The primary downside to these low rates is very limited customer service and limitations on how orders are directed to the market, but for traders who know what they are doing there is little reason to pay the full-service brokerage fees that are often three to five times these rates. Interestingly, institutional accounts often pay much higher fees to trade, with $3.00 per contract a common rate for the higher level of risk and broker-dealer capital required to execute the largest blocks.

If your commission schedule is at the high end of the range, don't be afraid to ask your broker for a discount. Account retention is a very high priority at all broker-dealers, and you may be surprised at how quickly your broker offers a discount to stay. If that doesn't work, and your capital base permits, consider opening a secondary brokerage account at one of the discount internet-based brokers. While there are drawbacks to managing two separate accounts, often times the difference in fees and trading platform functionality make this an optimal solution.

Exchange fees passed through by some brokers are another important factor to keep an eye on when trading. Lately, many exchanges have adopted a 'maker-taker' fee model, in which additional fees are charged for orders lifting offers or hitting bids (i.e. taking liquidity). With many brokers routing customer orders according to complex internal algorithms, it can be difficult to know when these fees will be incurred. Additional exchange fees include proprietary index royalties and fees for excessive cancels, resulting in a complicated and potentially costly fee structure in some cases.

The most significant cost for options traders is that of bid/ask spread. While penny pricing has resulted in tighter markets for many options, the difference between the bid and ask effectively represents a cost you will be forced to incur to get in and out of a trade. For example, in the following trade we can see a buyer paid $3.65 for 156 out of the money Apple (AAPL) calls:

The OptionAlert detail shows that the distance from bid to ask was $0.05, a transaction cost that will be realized by this buyer between the opening and closing of the trade. In other words, the buyer will need to see the option increase in price by a nickel just to get out for even (before commissions). In this case, the spread is about 1.4% of the value of the position, or $780 on a $57,000 investment. This is a significant amount given the short-term nature of the trade. The move to penny pricing has vastly improved things for retail traders, with many options quoted a penny or two wide for small size, but it is crucial to pay attention to the spread, and understand the risk reward accurately. The best way to avoid excessive bid/ask expense is to focus on the most liquid products as much as possible.

Capital costs and other subtle fees are the final issue to keep in mind. For traders who use margin accounts and borrow from their broker, the leverage can significantly improve returns, however, margin rates also vary widely, and interest charges come out of the bottom line, so you should shop around for the most aggressive rates offered. Even for the smallest account size, current margin rates among several large internet based brokers range from 1.67% to more than 7%.

U.S. equity option markets have never been as active or efficient as they are today. When properly managed, transaction costs for options traders can be very low given the leverage and unique risk profile of the instruments we trade. While commissions have been declining over time, the technology provided to account holders has continued to evolve, with leading brokers now offering free access to sophisticated tools that rival what many professional trading firms spent millions of dollars to develop in search for their 'edge.' Cost control is a fundamental part of any investing strategy, with a direct and immediate impact on bottom line results. Taking the time to make sure you are getting the most value for your trading dollar is clearly worth the effort.

Good luck in 2011!

At the time of publication, Henry Schwartz held no positions in the stocks or issues mentioned.

Henry is the president of Trade Alert LLC, a provider of real-time options analysis tools to leading Wall Street firms. His systems analyze hundreds of thousands of transactions per second to help professionals identify and interpret market activity in real time, supporting informed trading decisions and intelligent idea generation. He has held institutional trading and management roles with Bank of America, Bear Stearns, Salomon Brothers and the Hull Group, and made markets on the CBOE and AMEX floors in the US, and EUREX and MONEP overseas. Prior to founding Trade Alert, he led the electronic market-making group at Bank of America coincident with the launch of the International Securities Exchange.

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