David Burse loves trading stocks on-line. Since hooking up with Ameritrade four months ago, the San Francisco-based patent attorney says he has “traded a lot,” hopping in and out of stock positions, sometimes in a single day.
“It is perfect for people who know what (stocks) they want,” Burse says. “It reduces time. It’s easy. You can control the transaction. And it makes the whole commission cost a non-issue in your trading decisions.”
Indeed, over the last year, a virtual war has been waged over who will dominate on-line trading. This competition has sent the price of buying and selling stocks into the basement, with at least half a dozen major players offering to drop their commissions below $20 a pop for an average trade.
Yet Burse acknowledges that eliminating the financial and physical hurdles–high commissions and the need to talk to a broker, who just might muddy the waters with advice–that previously stood between an investor and his or her portfolio isn’t always a good thing.
“It is so easy and so cheap that it is very easy to trade more than you should,” Burse says. “When you have a significant cost in making a transaction, it makes you think twice and you may not do it. When you have no cost, you might get out of a stock prematurely just because of a bad day.”
Before the rise of on-line trading, investors had to trade by phone during normal business hours, and even the deepest discount brokerage typically charged at least $30 for a simple transaction. There were cheaper ways to trade, including signing up for dividend reinvestment, or DRIP, plans. But these programs are often slow and sometimes inconvenient.
Companies that offer dividend reinvestment plans, for instance, usually allow you to send the company a check to buy additional shares. You aren’t charged a commission, but the shares are purchased at the company’s leisure. It can take anywhere from a few days to a few months for the transaction to be completed.
Not so with on-line trading, whereby investors can research stocks at any one of dozens of sites, ranging from CNN-FN’s to one provided by the Securities and Exchange Commission. Investors can send in trading orders at any hour of the day or night. During business hours, a trade may be completed within seconds. Those who trade during the wee hours of the morning usually expect that the deal will go through soon after the market opens.
And transaction costs are minimal. Ameritrade charges just $8. Mr. Stock, E-Trade and Discover Brokerage charge $14.95. Others charge anywhere from $19.95 to $29.95, depending on the brokerage, the type of trade and the assets the investor holds in his or her account.
The low prices are a natural result of the low-cost structures that on-line trading firms enjoy, says Michael J. Anderson, president of Omaha-based Ameritrade.
“I have no research department, no branch offices, no commissioned salespeople,” Anderson says. “When your order comes in, the computer determines whether you have enough money in your account to do this. If you do, it fires the order to the market, which goes to a market maker to fill.”
From the brokerage’s standpoint, the only time human hands must touch your transaction would be if you’ve erred by asking for a trade when you don’t have enough money in your account to cover it.
Yet the lower prices also affect investor behavior, says Brent Houston, retail operations manager for Mr. Stock in San Francisco. Whereas the average individual is often referred to as a “buy-and-ignore” investor, the average on-line trader executes 20 transactions a month or nearly 250 trades per year, he says.
If you, like Burse, are trading in a taxable account, that could cost you a small fortune, regardless of brokerage fees. That’s because you must pay capital gains taxes on any security you sell at a profit, unless you have a capital loss to offset the gain. And capital gains rates are staggered to discourage short-term trading.
If you hold a stock for at least 18 months, you’ll pay the lowest capital gains tax of 20 percent of your profit. (The capital gains rate is 10 percent for those in the 15 percent federal tax bracket.) If you hold the stock for more than a year but less than 18 months, you’ll pay a maximum federal rate of 28 percent. If you own the stock for less than a year, you’ll pay at your ordinary federal income tax rate, which could be as high as 39.6 percent. And state taxes are added to that.
The bottom line: For a short-swing trade to make sense, your transaction must generate a return that pays the tax and trading costs and still leave you with a profit. That’s tough to do.
There is a way to trade and not get eaten up by taxes: Trade only in tax-favored savings accounts. If, for example, you own an individual retirement account, you can have the balance housed with your favorite on-line broker. Then if you want to trade actively, you’ll at least avoid the tax ramifications, although you’ll still have to grapple with the results of your decisions.
“There is nothing about Internet trading that makes me or anyone else any smarter about what to do,” Burse says. “It just reduces the cost of the transaction.”
