Speculating - Effect Of Commissions On Gross Profits

Effect Of Commissions On Gross Profits
Transaction costs are part of the equation and must be considered. As with securities brokerage, futures brokerage commissions range from "full service" to discount. A spread will likely be more expensive, but not necessarily twice as expensive, even though it is, in effect, two trades.

Any futures transaction carries at least two costs: one to open a position and another to close it.

LOOK OUT!
Read carefully how the exam words the question: does it state that you need to account for "$60 per commission" – in which case you count it twice – or "$60 in commissions" – in which case you count it once?

There are other carrying costs to consider as well: delivery costs for agricultural commodities, wire transfer and record keeping costs for financial instruments. In Treasury markets, incidentally, an investor may need to borrow the underlying asset to satisfy the exchange's requirement. This could add another 50 bps to the cost of the futures contract.

Unless otherwise instructed, assume these costs are figured into the commission or are negligible.

Return On (Margin) Equity Calculations
Ultimately, the speculator is not interested in how much money she made in raw terms. Rather, she is interested in how much she made as a proportion of how much money she invested. This is generally expressed as a percentage rather than a dollar figure.

The amount invested is not the original value of the contract, remember; it is mainly the margin. So say that the investor in the example we've been following had to put up 20% margin for an uncovered position or 5% for a spread. But there is another component of the investment: the commissions and associated transaction costs. Let us also assume she paid $25 per trade in commissions for uncovered positions or $40 per trade for spreads.

Formula 8.1
Amount invested = margin requirement + commissions

In the uncovered example, she would have had to lock in $1,942.95 ($9,464.75 for 100 contracts at $94.6475 each times 20%, plus $50 for two $25 trades).

Formula 8.2
(gross profit – amount invested) / amount invested = return on equity

In the winning case, her gross profit was $62,500. Her return on equity, then, would be 31.17% ([$62,500 – $1,942.95] / $1,942.95). Potential returns such as these with little investment out of pocket are the attraction of the futures market.

Now let us see what happens when things go wrong. The investment remains the same: $1,942.95 but now the gross profit is -$137,500. Her return on equity in this case would be -71.77% ([-$137,500 - $1,942.95] / $1,942.95), which will be awfully hard to explain to her boss.

How does spreading improve her position? First, as we have already seen, it reduces the swing between the upside and the downside, bracketing the price movements. But it will also tend to decrease the margin, more than offsetting any slightly higher commission fee, thus bringing down the amount invested.

In our example, the winning spread gave our speculator a gross profit of $25,000. Her amount invested would be $553.24 ($9,464.75 for 100 contracts at $94.6475 each times 5%, plus $80 for two spread trades). Her return on equity would be 4,418.83% ([$25,000 - $553.24] / $553.24). This is actually higher than the return on the uncovered position.

Now let's look at the losing spread that afforded a gross loss of -$6,250 for the same $553.24 investment. The return would be -1,229.71% ([-$6,250 - $553.24] / $553.24), still not pretty, but she could show her boss that it was much less painful than the -71.77% return she would have had with an uncovered position.

Tips & Tricks
You will almost certainly see a question about this is on the Series 3 exam. It could be about grains, livestock, foodstuffs, metals, energy, lumber, long-term interest rates, short-term interest rates, municipal bonds, currencies or stock indices. The theory (and the equation) remains the same: How much did the investor make (or lose) as a percentage of her initial investment?

Bear in mind that this is the pre-tax return on equity that we have learned about. For most purposes, this is as far as you need to go. However, you might see a question on the Series 3 exam that is asks you to compare a trade in a taxable eurodollar contract with a trade in tax-exempt municipal bond (muni) contracts. If you are given a taxable instrument and asked to compute at which tax-free rate the muni contract becomes favorable, the following calculation would apply.

  1. Determine the yield for the taxable transaction. Let's say that's given as 10%.
  2. Determine your client's income tax rate. Let's say that's given as 40%.
  3. Subtract the tax rate from 1. In this case, that gives us 0.6 (1.0 – 0.4).
  4. Multiply the taxable yield from Step 1 by the result of Step 3. To keep going with this example, the result is 6%.

.1 x (1-.4) = .06 tax-exempt yield

This means that a muni future need return only 6% to be as favorable, after tax, as the 10%-taxable yielding future. If the muni future yields more than 600%, it is more favorable; if it yields less than 600%, it is less favorable.

Alternately, the exam might ask for the equivalent taxable yield given the yield from the muni contract. Essentially, you do the above calculation backward:

  1. Determine the tax-exempt yield for the muni contract transaction. To keep the analysis symmetrical, let's say that's 6% (.06).
  2. Determine your client's income tax rate. Again, let's call that 40% (.4).
  3. Subtract the tax rate from 1. Again, that's 0.6
  4. Divide the tax-exempt yield from step 1 by the result of step 3. Our final result is 10%.

.06/(1-.4)=.10 tax-equivalent yield

Trading Applications


Related Articles
  1. Professionals

    Determining Muni Suitability For Clients

    FINRA Series 7 Online Study Guide Section 5
  2. Taxes

    Weighing The Tax Benefits Of Municipal Securities

    Find out how to determine whether the tax exemption offered by "munis" benefits you.
  3. Professionals

    Profit/Loss Calculations For Speculative Trades

    Profit/Loss Calculations For Speculative Trades
  4. Professionals

    Muni Taxes

    Series 7 Online Study Guide - Section 5: Municipal Securities, Muni Taxes
  5. Professionals

    After Tax Yield of a Taxable Security

    CFA Level 1 - After Tax Yield of a Taxable Security. Learn the relationship between taxable yields and tax-exempt issues. Provides samples on after-tax yield calculations.
  6. Options & Futures

    20 Investments: Municipal Bonds

    What Is It? Municipal bonds, or "munis" for short, are debt securities issued by a state, municipality or county to finance its capital expenditures. Such expenditures might include the construction ...
  7. Professionals

    Tax Implications

    FINRA Series 6 Exam Study Guide - Tax Implications. In this section, Tax Equivalent Yield. After tax Yield = Muni Bond Yield/100%-customer's tax bracket rate.
  8. Consolidating Your Retirement Money – Evaluate Performance

    Now that you know where you're going, it's time to see how well what you have matches your investment profile and objective(s).
  9. Professionals

    Municipal Bonds

    FINRA/NASAA Series 65: Section 8 Municipal Bonds. In this section calculation of taxable equivalent yield and general obligation and revenue bonds.
  10. Professionals

    Introduction

    FINRA Series 7 Online Study Guide Section 5 Municipal Securities
RELATED TERMS
  1. Yield Equivalence

    The interest rate on a taxable security that would render a return ...
  2. Performance Drag

    The negative effect of transaction costs on the performance of ...
  3. Gross Yield

    The yield on an investment before the deduction of taxes and ...
  4. Tax-Exempt Security

    A security in which the income produced is free from federal, ...
  5. Tax-Equivalent Yield

    The pretax yield that a taxable bond needs to possess for its ...
  6. Tax-Exempt Interest

    Interest income that is not subject to federal income tax. Tax-exempt ...
RELATED FAQS
  1. How are municipal bonds taxed?

    Discover information about trading municipal bonds, specifically the various tax implications municipal bonds have at state ... Read Answer >>
  2. What is the difference between yield and rate of return?

    Read about the differences between yield and rate of return. See why many novice investors often struggle more with the concept ... Read Answer >>
  3. What is the difference between gross income and taxable income?

    Understanding common tax terms including gross income and taxable income can help individuals navigate tax accounting in ... Read Answer >>
  4. What is the difference between the yield of stock and the yield of a bond?

    Explore and understand the various meanings of the investment term "yield" as it is applied to equity investments and bond ... Read Answer >>
  5. What is the difference between revenue and cost in gross margin?

    Discover the differences between revenue and cost in gross margin, along with an explanation of various measures of profitability. Read Answer >>
  6. What is the formula for calculating gross profit margin in Excel?

    Understand the basics of the gross profit margin including its interpretation as a measure of profitability and its calculation ... Read Answer >>
Hot Definitions
  1. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  2. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  3. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  4. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
  5. DuPont Analysis

    A method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are ...
  6. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
Trading Center