Costs of Trading

You now know the order types, account structures, and who facilitates trades. The final piece is understanding what trading actually costs. Commissions are explicit (separately charged); markups/markdowns are embedded in the price the customer pays, sometimes with separate confirmation disclosure; and other costs are implicit (built into the price you receive).

Explicit Costs

Commissions

• Fees charged by brokers for executing trades on behalf of clients
• Apply to agency transactions (the broker-dealer acts as an intermediary, not a counterparty)
• The amount may be a flat fee, a per-share charge, or a percentage of the trade value
• Must be disclosed on trade confirmations

Markups and Markdowns

• Apply to principal transactions (the broker-dealer trades from its own inventory)
• Markup: The amount added to the market price when the dealer sells to a customer
• Markdown: The amount subtracted from the market price when the dealer buys from a customer
• Must be fair and reasonable; the markup is embedded in the customer's net price rather than always itemized separately, though certain debt-security transactions trigger specific confirmation disclosure

FINRA's 5% Markup Policy:

• FINRA's 5% markup policy provides a guideline (not a hard rule or ceiling) that markups, markdowns, and also agency commissions generally should not exceed 5% of the prevailing market price
• The policy does not govern municipal securities, which are priced under separate MSRB fair-pricing standards
• Factors that may justify higher or lower markups include:
  • The type of security (equity vs. debt)
  • Availability of the security in the market
  • Dollar amount of the transaction
  • The broker-dealer's pattern of markups
  • The nature of the firm's business

Exam Tip: Gotchas

• The 5% markup policy is a guideline, not a rule. It is not a ceiling; markups above 5% are not automatically violations, and markups below 5% are not automatically reasonable.
• A firm charges a markup or a commission on a given trade, never both. If acting as principal, the cost is a markup/markdown. If acting as agent, the cost is a commission.

Implicit Costs

Bid-Ask Spread

• The spread is the difference between the bid (what buyers will pay) and the ask (what sellers will accept)
• This is an implicit cost because no separate fee is charged; if the investor buys at the ask and immediately sells at an unchanged bid, the round trip loses one full spread
• Actual cost depends on the execution price relative to prevailing quotes: an order can receive price improvement or execute at another price rather than crossing the full quoted spread
• Wider spreads = higher potential implicit costs = less liquid securities
• Narrower spreads = lower potential implicit costs = more liquid securities

Exam Tip: Gotchas

• The bid-ask spread is a real potential cost even though it does not appear as a separate line item. On a round-trip trade at unchanged quotes, the investor loses one full spread total (not the spread twice).
• Payment for order flow creates a conflict of interest. The broker may prioritize the market maker that pays the highest rebate over the one providing the best price for the customer.

Best Execution Obligation

• Best execution is the obligation of broker-dealers to seek the most favorable terms reasonably available for customer orders
• Governed by FINRA's best-execution rule
• Applies to both principal and agency transactions
• Factors considered when evaluating best execution include, among others:
  • Price improvement opportunities
  • Speed of execution
  • Likelihood of execution
  • Execution size and transaction costs
  • Customer needs and order-routing/payment-for-order-flow arrangements

Best execution does not mean the absolute best price on every trade. It means the broker-dealer must use reasonable diligence to find the best market for the security, considering all relevant factors.

Exam Tip: Gotchas

• Best execution applies to both principal and agency transactions, not just agency. A common wrong answer limits best execution to broker (agency) transactions only. It applies regardless of capacity.

Costs Comparison

What Should You Check on Exam Day?

• Commissions apply to agency trades and must be disclosed; markups/markdowns apply to principal trades and must be fair and reasonable.
• FINRA's 5% markup policy is a guideline (not a hard ceiling) that also covers agency commissions but not municipal securities; markups above 5% aren't automatically violations, and markups below 5% aren't automatically reasonable.
• The bid-ask spread is an implicit potential cost, even though it doesn't appear as a line item; a round trip at unchanged quotes loses one full spread total, not the spread twice.
• Payment for order flow must be disclosed and creates a potential conflict of interest.
• Best execution requires reasonable diligence across factors like price, speed, likelihood of execution, and execution size, and it applies to both principal and agency transactions, not just agency.