Over the past few weeks there has been a generational change in the brokerage business. Commissions have been dropping for many years, but now nearly every discount broker in the industry has moved to commission-free trading in most situations.
There are a number of reasons this phenomenon has occurred. Essentially it is a battle for custody of client funds. Brokers make most of their profits as a result of holding assets for clients rather than charging commissions. There are big profits for the brokers in idle cash and through the selling of their order flow.
This reduction in commissions is a huge benefit for many traders. I've talked with some very action-oriented traders who will save more than $100,000 a year in commissions and many will see a five-figure increase in profits if they don't change the way they trade.
With trading costs close to zero, the big question we must ask is whether more frequent trading is a good idea. Will you produce better returns if you simply double the number of trades that you make?
The answer is a very clear "maybe."
In one academic study of 66,000 investors the researchers divided investors into five groups based on their frequency of trading. They concluded that more active traders tended to be incorrectly overconfident, and that led to underperformance.
In another academic study of actively traded mutual funds, the authors found that funds with higher turnover produced better returns, especially when the fund was small and charged high fees for its advice.
The obvious conclusion is that if you are a "good" trader then you produce better returns by trading more. Many people incorrectly believe they are good traders and try to make up for their lack of skill by making more trades rather than fewer.
The ability to trade without cost is going to drive many "bad" traders to be even more active and they will produce worse returns. It is the lack of self-awareness that is the problem rather than anything inherent in more frequent trading. Doing more of the same behavior is a problem if it isn't working to begin with.
I've always been a big fan of incremental trading. I look to enter trades by making a number of partial buys and then exit the trade with a number of partial sells. This allows me to diversify by time frame and removes the inclination to be overly precise with entry and exit points. This approach is more difficult if you are working with limited capital and must deal with transaction costs, but with the elimination of commissions more traders should look at this style more closely to see if it works for them.
The key to using commission-free trading effectively is to become a better trader, and the No. 1 way to become a better trader is to have a plan. It is the emotional and impulsive trading that causes poor results and it is much easier to be impulsive and emotional when trades are free.
Commission-free trading is a huge benefit for hard-working traders who are disciplined and have a clear trading plan, but if you think that simply trading more is going to beneficial then you are very likely to find free trading to be extremely costly.