Why do most traders lose and wash out of the markets? Emotional and thoughtless trading are two reasons, but there is another. Markets are actually set up so that most traders must lose money. The trading industry kills traders with commissions and slippage. Most amateurs cannot believe this, just as medieval peasants could not believe that tiny invisible germs could kill them. If you ignore slippage and deal with a broker who charges high commissions, you are acting like a peasant who drinks from a communal pool during a cholera epidemic.
You pay commissions for entering and exiting trades. Slippage is the difference between the price at which you place your order and the price at which it gets filled. When you place a limit order, it is filled at your price or not at all. When you feel eager to enter or exit the market and give a market order, it is often filled at a worse price than prevailed when you placed it. The trading industry keeps draining huge amounts of money from the markets. Exchanges, regulators, brokers, and advisors live off the markets while generations of traders keep washing out. Markets need a fresh supply of losers just as builders of the ancient pyramids of Egypt needed a fresh supply of slaves. Losers bring money into the markets, which is necessary for the prosperity of the trading industry.
A Minus sum game
Brokers, exchanges, and advisors run marketing campaigns to attract more losers to the markets. Some mention that futures trading is a zero-sum game. They count on the fact that most people feel smarter than average and expect to win in a zero-sum game. Winners in a zero-sum game make as much as losers lose. If you and I bet $10 on the direction of the next 100-point move in the Dow, one of us will collect $10 and the other will lose $10. The person who is smarter should win this game over a period of time.
People buy the trading industry’s propaganda about the zero-sum game, take the bait and open trading accounts. They do not realize that trading is a minus-sum game. Winners receive less than what losers lose because the industry drains money from the market.
For example, roulette in a casino is a minus-sum game because the casino sweeps away 3 percent to 6 percent of all bets. This makes roulette unwinnable in the long run. You and I can get into in a minus-sum game if we make the same $10 bet on the next 100-point move in the Dow but deal through brokers. When we settle, the loser is out $13 and the winner collects only $7, while two brokers smile all the way to the bank.
Commissions and slippage are to traders what death and taxes are to all of us. They take some fun out of life and ultimately bring it to an end. A trader must support his broker and the machinery of exchanges before he collects a dime. Being simply “better than average” is not good enough. You have to be head and shoulders above the crowd to win a minus-sum game.
You can expect to pay a round-trip commission of anywhere from $12 to $100 for every futures contract you trade. Big traders who deal with discount houses pay less; small traders who deal with full-service brokers pay more. Amateurs ignore commissions while dreaming of fat profits. Brokers argue that commissions are tiny relative to the value of underlying contracts.
To understand the role of commissions, you need to compare them to your margin, not to the value of the contract. For example, you may pay $30 to trade a single contract of corn (5,000 bushels, worth approximately $10,000). A broker will say that the $30 commission is less than 1 percent of contract value. In reality, you have to deposit about $600 to trade a contract of corn. A $30 commission represents 5 percent of margin. This means you have to make 5 percent on the capital committed to the trade, simply to break even. If you trade corn four times a year, you will have to make a 20 percent annual profit to avoid losing money! Very few people can do this. Many money managers would give their eyeteeth for 20 percent annual returns. A “small commission” is not a nuisance- it is a major barrier to success!
Many amateurs generate 50 percent and more of their account size in commissions per year- if they last that long. Even discounted commissions raise a tall barrier to successful trading. I have heard brokers chuckle as they gos- siped about clients who beat their brains out just to stay even with the game. Shop for the lowest possible commissions. Do not be shy about bargaining for lower rates. I have heard many brokers complain about a shortage of customers- but not many customers complain about the shortage of brokers. Tell your broker it is in his best interest to charge you low commissions because you will survive and remain a client for a long time. Design a trad- ing system that will trade less often.
Slippage takes either piranha-sized or shark-sized bites out of your account whenever you enter and exit the markets. Slippage means having your orders filled at a different price than that which existed when you placed an order. It is like paying 30 cents for an apple in a grocery store even though the posted price is 29 cents. There are three kinds of slippage: common, volatility-based, and criminal. Common slippage is due to a spread between buying and selling prices. Floor traders maintain two prices in the market – the bid and the ask.
For example, your broker may quote you 390.45 for June S&P 500. If you want to buy a contract at the market, you’ll have to pay at least 390.50. If you want to sell at the market, you will receive 390.40 or less. Since each point is worth $5, the 10-point spread between bid and ask transfers $50 from your pocket to floor traders. They charge you for the privilege of enter- ing or exiting a trade.
The spread between bid and ask is legal. It tends to be narrow in big, liq- uid markets such as the S&P 500 and bonds, and much wider in thinly traded markets such as orange juice and cocoa. The exchanges claim that the spread is the price you pay for liquidity- being able to trade whenever you wish. Electronic trading promises to cut slippage.
Slippage rises with market volatility. Floor traders can get away with more in fast-moving markets. When the market begins to run, slippage goes through the roof. When the S&P 500 rallies or drops, you can get hit with a 20 to 30 point slippage, and sometimes 100 points or more. The third kind of slippage is caused by criminal activities of floor traders. They have many ways of stealing money from customers. Some put their bad trades into your account and keep good trades for themselves. This kind of activity and other criminal games were recently described in a book, Brokers, Bagmen and Moles, by David Greising and Laurie Morse.
When a hundred men spend day after day standing shoulder to shoulder in a small pit, they develop a camaraderiean “us against them” mentality. Floor traders have a nickname for outsiders which shows that they consider us less than human. They call us “paper” (as in “Is paper coming in today?”). That is why you have to take steps to protect yourself. To reduce slippage, trade liquid markets and avoid thin and fast-moving markets. Go long or short when the market is quiet. Use limit orders. Buy or sell at a specified price. Keep a record of prices at the time when you placed your order and have your broker fight the floor on your behalf when necessary.
Slippage and commissions make trading similar to swimming in a shark infected lagoon. Let us compare an example from a broker’s sales pitch to what happens in the real world. The “party line” goes like this: A contract of gold futures covers 100 ounces of gold. Five individuals buy a contract each from someone who sells five contracts short. Gold falls $4 and the buyers bail out, losing $4 per ounce or $400 per contract. The intelligent trader, who sold five contracts short, covers his position and makes $400 per contract, for a total of $2000.
In the real world, however, each loser has lost more than $400. He paid at least a $25 round-trip commission and was probably hit with $20 slippage coming and going. As a result, each loser lost $465 per contract and, as a group, they lost $2325. The winner, who sold 5 contracts short, probably paid a $15 round-trip commission and was hit with $10 slippage coming and going, reducing his gain by $35 per contract, or $175 for 5 contracts. He pocketed only $1825.
The winner thought he made $2000, but he received only $1825. The losers thought they lost $2000, but in fact they lost $2325. In total, fully $500 ($2325 – $1825) was siphoned from the table. The lion’s share was pocketed by floor traders and brokers who took a much bigger cut than any casino or a racetrack would dare! Other expenses also drain traders’ money. The cost of computers and data, fees for advisory services and books all come out of your trading funds.
Look for a broker with the cheapest commissions and watch him like a hawk. Design a trading system that gives signals relatively infrequently and allows you to enter markets during quiet times.
Trading for a living – Dr. Alexander Elder