Costs of Trading Securities

You now know the order types, account structures, and who facilitates trades. The final piece is understanding what trading actually costs. Some costs are explicit (you see them on a confirmation), and others 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

FINRA's 5% Markup Policy:

• FINRA Rule 2121 provides a guideline (not a hard rule or ceiling) that markups/markdowns generally should not exceed 5% of the prevailing market price
• Factors that may justify higher or lower markups include:
  • The type of security (stocks vs. bonds vs. municipal securities)
  • 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, but the investor loses the spread on a round-trip trade (buying at the ask and selling at the bid)
• Wider spreads = higher implicit costs = less liquid securities
• Narrower spreads = lower implicit costs = more liquid securities

Exam Tip: Gotchas

• The bid-ask spread is a real cost even though it does not appear as a separate line item. On a round-trip trade, the investor pays the spread twice (once buying at the ask, once selling at the bid).
• 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 Rule 5310
• Applies to both principal and agency transactions
• Factors considered when evaluating best execution:
  • Price improvement opportunities
  • Speed of execution
  • Likelihood of execution at the quoted price
  • Settlement efficiency

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