Institutional and retail traders alike can benefit from reduced trading costs. Commissions, fees, software costs, entitlements, and other expenses can cut into profits and in many cases slide the net profit/loss results into the negative.
Institutional traders are well aware of trading fees and try to reduce fees as much as possible while still balancing liquidity and attempting to maximize profits and minimize losses. The retail trader using a broker while trading from home can also reduce fees, especially fees specifically related to trading commissions.
Using different order types and market centers, many direct access retail brokers now pass along credits to traders for providing liquidity to the market. This can reduce the cost of entering and exiting trades. Over the long run, by altering our entry and exit strategy slightly, a lot of money can be saved in fees.
The Credit/Debit Structure
An electronic communication network (ECN) is an electronic marketplace that allows traders to trade with one another on an exchange. Most volume is now traded through ECNs in the stock market. If you have access to a "Level II" screen, you will see the current bid and offer, as well as the volume that is being bid or offered by multiple participants on each ECN at that price. If no one is bidding/offering on a particular ECN, that ECN will not appear at that price on the Level II. It should be noted that you do not need to see a Level II in order to collect credits to offset commissions, you only need to know how and where to place your orders.
Let's take an example of a stock with a bid price of 25.25 and an ask price of 25.26. If you offer to sell (or short sell) at 25.26 and wait to get filled, you will have provided liquidity and will be credited on many ECNs. On the other hand, if you sell (or short sell) with a market order at 25.25 you will be charged or debited an additional fee on many ECNs because you have removed liquidity. The same works for the bid: If you bid at 25.25 and wait to get filled, you will be credited; if you market a buy at 25.26, you are removing liquidity and will be debited. The debit for removing liquidity is almost always more than the credit for providing liquidity. (For related insight, read more about the basics of the bid-ask spread.)
Which ECNs to Trade With
ECNs and exchanges are continually updating their fee and credit/debit structures. Therefore, it is very important to check with your broker on what the current credits and fees are, and if the broker will pass along credits to you. We will look at several examples of the credits/debits with current ECNs to provide an understanding of how the structure works.
ARCA is one of the major ECNs on the U.S. stock markets. As of 2009, ARCA provides a 0.0023 credit for providing liquidity. If liquidity is removed, the charge is 0.003. On 1,000 shares, this means we can make $2.30 for simply providing liquidity and waiting for our bid or offer to get filled, or we will pay $3 to enter the market by removing liquidity. If you provide liquidity on the entry and exit with 1,000 shares, you make $4.60, as opposed to losing $6 if you remove liquidity on the way in and out. That is a $10.60 difference on each round trip with 1,000 shares. When tabulating actual trading profits or losses, factoring in these costs can have a dramatic effect on the bottom line, especially for active traders.
ARCA, Nasdaq, BATS and EDGX are high-volume ECNs that provide a credit structure similar to the example above. Each ECN will have slightly different credit and debit amounts. (You can get related insight by reading more about the birth of stock exchanges.)
Some ECNs do not charge for removing liquidity, or the fee is very low. This can also help in managing fees, as a low-cost ECN (or free ECN) can be used to remove liquidity, and when providing liquidity use an ECN that provides higher credits.
Let's look at a simplified trade example using the above information. A stock has a bid of 25.25 and an offer of 25.26. You want to purchase 1,000 shares. If you had no other fees, bid at 25.25 and are filled, your account will be credited with $2.30 (on ARCA, for example). If our broker charges a commission of $5 (or his or her per-share fee multiplied by the shares traded), the $2.30 credit will offset this amount, making the net cost of the trade $2.70.
On the other hand, if you remove liquidity you will be charged $3 (debited), in addition to the broker's commission. If the broker charges $5 for this 1,000 share trade, the total cost of the transaction will come to $8 ($5+$3) – a significant difference from the $2.70 cost when providing liquidity.
Please note that there are other fees involved in trading, and this is a simplified example to show how fees can be reduced based on how orders are executed.
The Downside and Upside
There is a downside to focusing too much on credits. While credits can offset some trading costs, for most traders receiving the credit is fairly insignificant on each trade, although it definitely adds up over many trades. When the market is moving quickly, it is not always prudent to bid to get long, waiting to get filled simply to attain the credit. There are times when removing liquidity to enter a fast-moving stock will be required. This is also important to remember when the market is nearing a stop price on your trade. If you are long on a stock and the price is falling and closing in on your stop, offering your shares out on the offer price may not be logical, as the order may not get filled and prices may continue to fall.
The upside of trading while being conscious of managing fees is that not only will we gain credits, but we will also get a better price. By buying at the bid price (or selling at the offer price), and collecting credits, we can increase our gross and net profit numbers over using market orders. (For more, read about how trading is timing.)
The Bottom Line
Whether most traders are aware of it or not, this is how the stock market works. Certain retail brokers are allowing their clients to partake in the credit and debit system, and some are not. Check with your broker to see if you can access certain ECNs to take advantage of ECN credits.
Even though reducing trading costs can be alluring, it is important not to focus on it completely. Removing liquidity is needed in some circumstances to enter or exit trades quickly. It is also important to note that different trading systems and styles will almost always remove liquidity and thus have inherently higher fees. That is fine; it is balancing execution, fees, profits and liquidity that is important. This is up to each trader to work out in their own trading plan. (To learn more, check out our Brokers and Online Trading Tutorial.)