Charles Schwab Ditches Commissions, Industry Reels

Charles Schwab

Trading commissions have been going down ever since discount brokerages first appeared on the scene. Charles Schwab has now gone all in with zero commissions.

At one time, not that long ago, placing orders for stocks was an expensive affair indeed. Brokers didn’t call themselves full-service brokerages back then because all brokers were full-service. Trading costs were extremely high compared to today, where the average commission was about a percentage point, each way.

If you placed a trade for $10,000 of stock, this means a commission of $200 or more. A couple of percent might not sound like that much, and it was small enough that most people just paid it without questioning it too much, but such a high rate of commission had a lot bigger effect on things than people realized.

It’s actually not so much that they didn’t realize it as much as it placed considerable restrictions on how people traded. The biggest thing about these high commissions wasn’t just the cost, it was the strategic limitations that this placed upon traders.

If you use a trading style that seeks to capture a 1% gain, and when the trade works, you lose 1% overall, that obviously isn’t going to work. If the trade did not work and you lost 1% on it, you actually lost 3%.

Whatever gain that you need to shoot for will have to be considerably greater than your trading costs, which includes both the spread and the commissions. Spreads weren’t anywhere near as tight as they are now back then, so there was a lot to overcome back then and this actually made trading too difficult, because the returns you’d need to go after were the sort that investors would be aiming for, by holding something for quite a while.

We couldn’t really time the market effectively short term in other words, and this meant that a lot of potential liquidity that we could have had wasn’t allowed to bloom. Trading is already a difficult enough proposition without commissions, but these high commissions made it virtually impossible for individual traders to get into the game, and trading was then left up to the big institutions.

This even affected investing, if it cost you 2% or more for a round-trip trade, this makes it a lot more difficult to time markets in an efficient way. This reinforced the strategy of buy and hold as timing stocks was made far more difficult, even though you might not think that 2% would make this much difference, but it did and would today as well even with the lot tighter spreads that we have now.

These tighter spreads are actually a result of the much lower trading costs that we see in modern times, compared to the 1970’s and before when it cost a lot more to trade and hardly anyone did it. A lot of this came from institutions trading more cheaply as well. The less it costs to trade, whether you are a big investment bank or a person trading a small account with a retail broker, the more efficient markets are and the better you will do, since you get to keep more of your profits and your losses aren’t piled up on with trading costs.

Discount Brokerages Have Been Coming More and More to the Rescue

Since the mid 1970’s, trading costs have steadily declined, as discount brokerages came on the scene and started offering their clients more streamlined processes and lower fees. The emergence of online trading saw these costs reduced further, as their costs not only went down, but this also increased the competition among discount retail brokerages.

This has continued to this day, and on Tuesday, discount broker Charles Schwab went all the way, announcing that they are eliminating online trading commissions on stocks, ETFs, and options. This doesn’t mean zero trading costs, as brokers do provide a service and still need to get paid, but the ability to trade without lump-sum amounts added to their costs is a huge step forward for retail trading and investing.

We’ve now come full circle from the times where brokers were widely accused of bilking their clients with their high fees, which was at least partially true, to now where you can do this without paying any commission. Brokers still make money through their order flow, and depending on how your order is executed this could cost you a little more, but brokers already do this and the commissions have always been on top of this. The top has been carved off with Schwab now and all that is left is the bare bones so to speak, which means that this is as good as it gets for traders.

This is not only a big deal for those who trade shorter-term, it’s also big for investors as well, especially those who like to invest over time. No-load mutual funds have had a big edge with this segment, those who want to invest a certain amount per pay or per month, and you don’t want to be paying $4.95 or more every time you want to add shares of an ETF with these small amounts.

This levels the playing field with no-load mutual funds on the issue of commissions, and given that ETFs have the advantage in other areas, we should expect ETFs to really gain in popularity now as more and more people realize that they can load them without fees as well now.

The impact upon the mutual fund industry won’t likely be felt all that much for a while, but this is not good news for them, as this will cause an acceleration of the migration of people out of mutual funds and into the more modern, more convenient, and less expensive exchange traded funds. If you can trade them now without commissions, this eliminates the only real advantage that mutual funds have had and ETFs now win by a clean sweep.

The old adage that traders only make money for their brokers, which was true a long time ago but not so much now, will also be put to rest. With commissions in place, you still need to take these costs into account and even $10 round trip can make a difference, but no more. Traders will now only need to worry about covering the spread and this makes trading not only cheaper but more transparent as well.

The price you entered and exited will now have a direct relationship, and if you got out right where you entered, you will now not lose money. Traders pay a lot in commissions even at the low commission rates of today, because they place so many trades, so this is a day well worth celebrating for everyone who trades and invests.

Commissions Are About to Hit Rock Bottom, Literally

The only way that you could really trade commission free was to trade with a CFD broker, although even they charge commissions on stock trades and you’d have to trade indexes or other non-stock securities. For Americans, they have been limited to just placing forex trades with them, as other types of securities are not permitted to be traded with these brokers, at least not yet.

People who have not traded commission-free probably won’t be able to fully appreciate what sort of advantage this is with trading, as you can’t just add up the commissions that you paid in a year and assume that this the whole deal.

Commission-free trading not only saves you what you were paying but allows you to trade more efficiently and make money from trades that you simply couldn’t with commissions, as well as make more money from each and every trade of course. This essentially means that the only limiting factor now is the spread and the days of needing to shoot for higher gains and take on higher risks doing it just because commissions require this have now been put to rest.

Charles Schwab is expected to take a real hit on their bottom line, but the damage is not expected to be all that bad. Their earnings are only expected to drop by 7% from this, which is quite modest indeed considering what they just gave up.

Their main competitors are on notice though and they will have to at least slash their commissions, if not eliminate them as well, in order to keep up. Discount brokerages are still somewhat relationship driven, so many clients may be willing to pay a little more rather than move to Schwab, but there are real limits on this and paying the same old commissions just won’t cut it.

The fact that TD Ameritrade and E*Trade will need to be cutting their trading commissions wasn’t lost on the market though. While Schwab stock dropped 10% on Tuesday, E*Trade gave up an even more disturbing 16%, and TD Ameritrade simply got hammered by losing a quarter of their value in one day.

Both of Schwab’s main competitors rely more on commissions for their earnings than they do, and both competitors are projected to see their earnings drop by 22% from this, as opposed to only 7% with Schwab.

It is as if Schwab invited a monster into the room, realizing that they can wear their armor, and take much less damage than their rivals who really got beat up by this. This may be using a competitive advantage in reverse but this can be pretty effective in gaining more market share and still make marginal profit on this gain.

Shareholders of all of these companies are of course going to be disappointed, but if you own Schwab stock, your side might be in a war but is in one that they are poised to win. The opponents will lose even more and their losses then may become your gain eventually.

It actually might be difficult for them to match this offer, and if they don’t, all the hoopla from this event will have Schwab’s zero commissions in the minds of a great many people, without their having to spend a dime on advertising. You can bet that they will though, making this advantage even more known.

The damage to Schwab’s stock was done during overnight trading though, and they actually closed a hair higher than they opened. Since people usually over-react to these things, it may be worth watching to see if it can regain at least part of this once the shock wears off and more people realize that this move probably isn’t as bad as it appears.

You can’t buy the stock commission free just yet, but this is all set to roll out on October 7, which is less than a week away.

Charles Schwab himself has told people that he wants to make investing even more friendly, going forward and the company he founded has certainly backed up this idea. This extra friendliness will cost the company, but will also solidify and likely increase their position in the market, as well as make a whole lot of people happy. This is a bold move indeed but one that deserves our applause, our thanks, and maybe even a bow.

Charles R. Schwab was the pioneer of discount brokerages, so it is only fitting that his company be the first to lower that discount all the way to zero. The game is really on now.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.