Commission has great impact in your day trading system’s profitability and efficiency. Commission might be the only reason you are not a profitable day trader, simply because it is charged in every little trade you make intraday. Commission greatly affects your trading system’s win/loss ratio and the effect is magnified, if you are tightening your stop loss and profit target orders. The less ticks you are aiming to profit from, the more commission takes away a chunk of your profits. By knowing how much impact commission makes to your day trading strategy right from the beginning, you can improve your system’s long-term expectations.
Let’s take an example to make commission effect clearer. I day traded 7 stocks during yesterday’s US regular trading session, willing to risk $100 per trade and aim for $100 win in each trade – although those limit orders weren’t hit for some stocks and I had to trade out when the market closed, hence a couple of small wins. It doesn’t take a genius to realize that if a day trader with such a trading system wins more than 50% of their trades, he will make money in the long run. However commission is not calculated in those figures. But for a moment there, let’s assume traders are not charged commission for their trading activities. Then, according to proper money management and using bracket orders to define stop loss and profit target points, a day trader should buy 1,000 shares of a stock when he risks 10 ticks, 500 shares when risk is 20 ticks, 200 shares for 50 ticks’ risk and so on. Ok, been there, done that for most traders, that’s simply basic money management, let’s move on.
Unless commission is charged, the day trader who succeeds 55% in his trading, he will be making 1 tick per trade in the long run. In my example of trading system, I will win 55 times $100 and lose 45 times $100, which equates to $1,000 profit after 100 completed trades.
Now commission is charged. Let us assume that all of my trades have 10 ticks stop loss/profit target bracket orders. Commission in Interactive Brokers is roughly 1 tick per completed trade, that is a complete buy and sell order. So, when the profit target is hit, I will be actually making 9 ticks profit, while losing trades will cost me 11 ticks due to commission. In that case, if my day trading system has a 50% winning probability, I’m losing money! I remind you it’s still the same system we talked in the beginning. Therefore, in order to make money now, the day trader needs better than 55% success rate, a figure that was profitable before!
The commission effect lessens the more loose our orders get. For instance, if the day trading system includes trades of 50 ticks stop loss/profit target exclusively, a winning trade will make 49 ticks profit and a losing one will cost 51 ticks. Now, the day trader needs just 51% success rate to break even. Obviously the more ticks you are aiming for, the success rate needed to make money reduces.
On the other hand the day trader can include commission effect into their orders. For example, in case of a 10 ticks’ trade, they could set an 11-tick profit target and a 9-tick stop loss. A winning day trade would then make 10 ticks after commission, and a losing would cost 10 ticks once again. However this time they need 50% winning probability to break even at first glance, when the breakeven point is in fact at 45% success rate (11 ticks profit for 9 ticks loss). In this scenario they have to improve their system’s success rate by 11% (+5% in 45%), while in the scenario mentioned before the improvement needs to be 10% (+5% in 50%).
As a conclusion, it’s better to aim for a better winning probability (aka success rate) than including commission in your stop loss and profit target orders. Of course, a very important rule in day trading is finding a reliable broker with reasonable commission at first place!