choosing a broker

A reader we’ll call Moose (name changed to protect the guilty) just emailed me the following question:

Michael, how should I compare commissions between my current broker (OptionsXpress) and TradeKing?

Sounds like Mr. Moose is thinking about switching! First things first…

Really consider why you are switching. If you are happy with your current broker – particularly when it comes to customer service, you shouldn’t switch, unless you are really going to save some money by changing.

Here’s how I would do the math:

I would start out with some figures from 2009. I’d be looking at my P&L (AFTER commissions) for the year and the amount I paid in commissions compared to what I would have paid with Broker X.

So let’s say my P&L for the year after commissions was $20,000, and I’ll assume that I paid $1000 in commissions on 100 stock trades ($10 per trade). I’m using round numbers here to keep it easy – these don’t apply to any broker.

Now if broker X charges $8 a trade – I’d save $2 a trade times 100 trades. That’s $200, which would improve P&L by just 1%. That’s not worth switching for unless customer service is an issue.

On the other hand, if you make 1,000 trades a year and could save $5 a trade, you’d be picking up an extra five grand just for filling out some online forms to switch. That’s a food budget for a small family for a year, or in my case, a shiny new camera. And if you’re a megatrader moving thousands of trades a month, the savings could easily go into the six figures – of course, that’s a minority that isn’t reading this article.

Another issue to consider is execution quality. Meaning, will your trades be completed in a timely fashion at the best possible prices?

This is the hardest issue to quantify, especially when it comes to highly-liquid markets like equities where orders can be filled in the blink of an eye. It’s also an issue that isn’t really relevant for buy & hold types.

My rule of thumb is that on stock orders, you should get a slightly better price than your limit at least some of the time. If I had to guess, I’d say that Thinkorswim gives me price improvement on one out of three stock trades. On options trades, it happens occasionally but definitely not often.

If you never get price improvement, you’re geting screwed.

Here’s how I’d roughly calculate the potential effect of crappy executions:

Take your P&L for 2009, and subtract a miniscule amount – 0.2% or less.

Then, either by using an Excel function or doing it blindly by hand, randomly select a few trades from 2009.  And screw yourself by 5% . Either add 5% to your loss on a randomly selected trade, or reduce your profit by 5%. This is intended to simulate the impact of the broker not being able to get your big trades done at crunch time.

Take these numbers, and factor them into your estimates on how a new broker impacts your P&L. If you’d save $300 on commissions with a possible $50 negative impact on the execution side, you really have no reason to switch unless you’re dissatisfied with customer service, or continually getting hit with stupid service charges.

If it seems like I’m overemphasizing customer service, it’s because I am. Customer service should be the primary consideration for most investors. Fancy charting packages and cheap commissions don’t mean squat when you’re on hold for 45 minutes. I save money where I can, but I’ll always pay up for companies with live, helpful humans.

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