Commission Costs in Option Trading
Back to Boomers Investment Library
Commission costs are considerably higher in option trading compared to stock trading.
If you buy 100 shares of a $50 stock, you would shell out $5,000 plus about a $10 commission at your favorite discount broker. The only thing you know for certain about this purchase is that it ties up $5,010 that could be earning interest in a savings account.
A year later, unless the stock has increased in value, you still would not have covered the money you paid out for the commission. Even though the commission works out to only 0.2% of the total investment, it is no wonder that commissions are a concern for stock traders.
Contrast the stock purchase to the sale of a single option for $1.50 (a one-month at-the-money call or put option on SPY could be sold for almost double this amount, but let’s take the lower number). On the $150 sale, a typical discount broker might charge a commission of $1.50. This works out to 1% of the purchase price, or 5 times the percentage you would have paid to buy the stock.
However, the option seller has sold a depreciating asset that goes down in value every day. Over the course of the next month, the time premium of the option that was sold for $150 will depreciate by an average of $5 per day. In other words, one day after selling the option, if the stock price doesn’t change, the commission cost will have been totally recovered more than 3 times over.
Of course, if a call were sold and the stock went up, the option that was sold for $1.50 might cost more to buy back the next day, but the option-seller presumably owns an off-setting longer-term call that will also increase in value. But the bottom line is the same – every single day of the short option’s life, the entire commission cost will be more than covered by the lowering value (decay) of the option.
The buyer of stock might have to wait a year or more for the stock to go up and finally cover his commission cost while the option seller will cover his commission cost before lunch-time the following day.
In his mind, the option-seller should think of the commission cost as evidence that he has made a good investment that will pay for itself in less than a day. The more commissions you pay, the more decay you will be collecting.
This is just another example that the world of stock investing is far different from the world of option investing. While it may take a year to recover the commission you pay on a stock purchase, you would be disappointed if it took an entire day to recover that cost if you sold an option.
In spite of the extraordinary transaction costs of option trading, there are many option newsletters on the Internet which report their returns without recognizing commission costs. I can’t understand how they stay in business.
It is best to think of transaction costs in an options portfolio as you would the interest costs of a commercial real estate investment. Interest might amount to 60% or more of your rental income, but if your net return was attractive, you wouldn’t give the interest cost a second thought. It is only a necessary cost of owning that kind of investment.
Many people foolishly compare their commission costs in an option portfolio to the commission costs of trading stocks or mutual funds. That is a mistake. Anyone who focuses on transaction costs rather than the bottom line should not be trading options.
I believe the net gains from the 10K Strategy should be far greater than virtually any mutual fund or real estate investment even after the extraordinarily high transaction costs are covered.