I have had a few people ask me about commission free trading and what the catch is ?
Well, I must admit that I don’t use commission free trading, as I work as a technical analyst for a futures and options dealing business, so I trade my own account through the firm I work for.
To find out a bit more about commission free trading, I rang a good friend of mine who occasionally trades on a commission free basis.
He referred me to a trader’s web-site where many discussions were taking place on the pros and cons of commission free trading.
Commission free trading dates back to the “bucket shop” days of the late 1920’s, when small broking firms were set up around the United States to allow people who weren’t in New York, the ability to trade stocks listed on the New York Stock Exchange.
How the bucket shops worked was, they had a black board of stocks that were trading in New York.
Each “bucket shop” had a stock ticker, which kept the office informed of the current prices on the official exchange.
As the stock prices fluctuated during the day, the “chalkies” at the “bucket shops” would altar the bid/ ask spreads on the blackboard.
How they worked was, the “bucket shops” offered a bid and asking price for the stocks they quoted on.
The bid price they offered enabled the shop to buy the quoted stock at a discount to the official bid price on the exchange. Conversely, the asking price quoted by the “bucket shop” was at a premium to asking price on the exchange.
This allowed the “bucket shop” to buy the stock from the exchange and sell it at a premium to the clients of the shop. It also allowed the shop to buy stock cheaply from its’ clients, then sell the stock immediately for a profit on the official exchange.
This is similar to how “market makers” operate in derivative markets.
Market makers offer a bid and asking price in a contract that they make markets in.
The distance between the buy and sell price is called the “spread”.
When the volatility in a market picks up, the spread tends to widen as the market makers need to hedge themselves against risk in another market.
For example, let’s assume that NCP is currently bid at $11.55 and offered at $11.57.
The short dated call options that have a strike of $11.50 will probably be quoted by the market maker at 75c bid 80c offered.
If somebody buys the $11.50 call options at 80c, the market maker is agreeing to sell NCP at 12.30.
As soon as the trade is executed, the market maker will buy the physical stock at $11.57 to hedge the trade.
Let’s now assume that somebody sells the NCP $11.50 call options at 75c to the market maker.
The market maker is now long the stock at $10.75. To hedge this position, the market maker will then short the physical stock at $11.55.
When you are trading on a commission free basis, you are basically taking the other side of the trading firm’s trade, as they act as the principal on all trades.
