Understanding the High Cost of Frequent Trading

In this episode of Industry Focus: Consumer Goods and as part of our "Never Will I Ever" theme week, Vincent Shen welcomes senior Fool.com contributor Asit Sharma on air to share some insight on the pitfalls of day trading.

If you trade stocks frequently, it's a good idea to understand what the "vigorish" is. According to Victor Niederhoffer, author of The Education of a Speculator, trading costs can have huge implications on your returns.

A full transcript follows the video.

This video was recorded on July 11, 2017.

Asit Sharma: The first insight is, the bid-ask spread works against you in frequent trading. Vince, if I can ask you, for our listeners who don't know, to define what the bid-ask spread is, and then we'll tell you what Victor Niederhoffer's very particular take on this is.

Vincent Shen: Sure thing. For the bid-ask spread, you basically have two sides of the supply and demand equation. On the supply side, it's the asking price for the security, basically the minimum that someone is going to accept in order to sell. Then, you have the demand side of the equation, the bid, and that's the most someone is willing to pay in order to buy. The difference between them is the bid-ask spread. The reason this spread exists, just some background, is to compensate the market maker for the security. Just like it sounds, the market maker is usually a large brokerage or bank, and they take on risk by essentially holding an inventory of security, whether it's stock or options, and quickly fulfilling orders as they come through.

If you've ever wondered how it is that you can sell, for example, your 129 shares of company XYZ at the push of a button, those are not going directly to some buyer on the other side of the country or the globe, but the market maker picks them up. For more well-known, liquid stocks, for example, the spread is pretty small and pretty insignificant, since the market maker can quickly find buyers and sellers who are on the same page as to the value of each share. They might charge you one penny or two for the spread. But when you start getting into smaller and more obscure companies with less trading volume, you'll see the bid-ask spread widen, since the market maker will take on the shares you're selling and have to hold them potentially longer before finding a buyer. In the meantime, the value of that stock or security can change. The last thing they want to do is sell the shares at a lower price than they purchased them and rack up losses.

Sharma: Absolutely. That's a really great definition of the bid-ask spread and its implications. Victor Niederhoffer first observed this when he was a kid, hustling handball games on the streets of Brighton Beach. From an early age, he learned about how trading works by essentially being this kid gambler who was very good in handball. He went on to be a national squash champion, by the way, in his years at Harvard. But what Victor observed is that bookies would collect bets while he played. And what he tells us is, the bid-ask spread, what the market makers take in compensation for providing liquidity, is the same thing as the vigorish in the gambling world. The vigorish, or the vig, as it's more commonly known, is the commission that a bookie takes in order for you to place a bet. The ideal situation for a bookie is that he or she will collect equal bets from both sides of a wager on an event. That commission that he's charging each side is the bookie's vig, the vigorish. And Niederhoffer observes, in gambling, people get eaten up by the vig, but the same thing is true in the markets. You're essentially paying vig to the brokerage houses, or the market makers by extension, when you trade frequently. This has enormous implications for those who consider their transaction costs.

I want to talk a little bit about the implication of size of the stock that you're trading, in terms of its total market capitalization. Vince, I know that you and I exchanged some notes. One of those was a slide by the famous finance and valuation expert at NYU, professor Aswath Damodaran. Professor Damodaran's slide in this particular study that we looked at showed that wider bid-ask spreads were associated with stocks that have a low market capitalization. For a high capitalization stock, those bid-ask spreads tend to narrow very much. So traders, there's some logic here that hit home to me when I was trading, that may be hitting home to you, if you're out there day trading. The stocks that you need to trade to make money in the stock market are the ones that are more volatile. And the ones that are more volatile, with the higher betas, those are smaller capitalization stocks for the most part. The biggest stock price movements during the day are correlated with stocks with low market capitalization. And professor Damodaran tells us, those have wide bid-ask spreads.