Day trading has been around for decades but has gotten a big boost recently. Back when brokerage companies charged commissions for each stock trade, trying to buy and sell the same stock multiple times a day could end up being extremely costly. Now that commissions have largely disappeared, though, day trading has become a seemingly more attractive and viable strategy to pursue.
Yet even without commissions to pay, there’s another cost involved with day trading that can add up over time. Ultimately, it can threaten a day trader’s ability to trade profitably.
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Dealing with the bid-ask spread
To understand why there are additional trading costs, even in a commission-free environment, you need to know the way that stock trading typically works. When you place an order for a stock, a professional known as a market maker is often on the other side of the trade, buying shares from those looking to sell and selling them to those who want to buy.
The market maker needs to make money. So when an investor wants to sell shares, the market maker is willing to buy them but looks to pay a price slightly lower than the current market price. Conversely, if a different investor wants to buy shares, the market maker has stock to sell but asks for a slightly higher price than where the market is.
For the biggest stocks, the gap between the price the market maker is willing to pay to buy shares (the bid price) and the price the market maker is willing to accept to sell shares (the ask price) is typically quite narrow. The gap is known as the bid-ask spread, and it’s not uncommon to find gaps of just $0.01 per share on certain stocks that have a lot of trading volume and liquidity. Also, the higher the share price, the wider the spread is likely to be.
The difference between these two prices represents potential profit for the market maker. However, it’s a cost that the market-maker’s customers have to bear. The more often you trade, the more often you’re paying this cost.
The impact of spreads between bid and ask prices
Obviously, if the spread is fairly narrow, it’ll take a lot of day trading to have a large impact on trading results. For instance, if Apple is trading at $190 per share with a spread of $0.01 and you buy and sell 100-share blocks 10 times a day, you’ll end up losing about $10. That’s 0.05% of the value of 100 shares of Apple stock.
However, if you trade constantly, eventually those numbers will add up. Paying 0.05% per day works out to 12.5% of your investment over the course of a year. Sure, your stock might rise that much in a given year, but it’s not a certainty. In any event, losing that much to trading costs will take a big bite out of whatever profits you’re able to realize.
The bid-ask spread really takes its toll on thinly traded stocks. There, the size of the spread can be much larger.
For instance, if you pay a $0.04 per-share spread on a $7.50 per-share stock, then each purchase and sale will cost you more than 0.5%. Do that 10 times a day, and you’ll have to overcome a 5% headwind on a daily basis just to break even. And unfortunately, it’s often those thinly traded stocks that are the most popular targets for day traders.
Moreover, the spread can be especially frustrating for day traders if a stock doesn’t move much during the day. In that case, the volume-weighted average price (VWAP) for the stock that day might well be between the bid price and the ask price. Yet for every trade, the day trader pays more than the VWAP for purchases and receives less than the VWAP in proceeds from sales.
Pay trading costs less often
Long-term investors also bear the expense of dealing with the bid-ask spread, but the advantage they have is that they deal with it less frequently. If your typical holding period is several years rather than several minutes, then facing a 0.05% or even 0.5% bid-ask spread won’t be nearly as detrimental. That’s just one more reason why day trading is so much harder than long-term investing.
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Dan Caplinger has positions in Apple. The Motley Fool has positions in and recommends Apple. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
