Commission free ETF purchases offered from brokers similar to Questrade (in Canada) are quite appealing to the average index investor. Great deals are often greeted by many people taking advantage of the opportunity presented. My suggestion is to make certain that you fully understand the entire price details from the broker that you are signing your life away with. One area that I felt was difficult to understand was ECN fees. What are they, how do they apply and can I actually avoid them?
What are ECN fees?
ECN fees is a term used to lump all of the Electronic Communication Network fees and alternate trading fees together. Where this originates is the exchanges and networks that are responsible for matching a seller to a buyer or vice versa. When we say exchange we are talking about the NASDAQ, New York Stock Exchange and the Toronto Stock Exchange just as a few examples.
How do ECN fees apply?
ECN fees apply to the end user (you) depending on the broker that you sign up with. Many independent brokers have ECN fees that directly apply to the end user and you can review the ECN fees with the broker that you are with or considering. Major brokers may hide this fee as it would be built in to the fixed fees that they charge. This would also be in your pricing details with that broker.
Let’s break down how ECN fees are generally charged to your purchase or sale of an asset. Let’s say for example that we are purchasing 1000 shares of a large company that has a price of $10.00 per share. The important bit of information that we need in order to calculate the ECN fees is the number of shares. ECN fees are share based. Let’s also say that the broker charges $0.0035 per share. The fee can be different depending on which stock exchange the asset is on that you wish to trade.
Now let’s go ahead and calculate the ECN fees that would apply. 1000 shares multiplied by $0.0035 is equal to $3.50.
The total ECN fees that we would pay is equal to the $3.50 that we had calculated. If your broker charges $6.99 per trade plus ECN fees, you would then pay a total $10.49 to complete the trade.
Is it possible to avoid the fees?
The short answer is yes it is possible to avoid ECN fees. Understanding how to avoid the fees is not all that easy to understand, so let’s go through it. In a trade only the buy or sell order that removes liquidity from the market pays the ECN fees. When you place an order on the market for an asset and the transaction happens instantaneously it’s safe to assume that you had removed liquidity from the market. However if you place an order in such a way to add liquidity to the market, you will avoid ECN fees when your trade is matched with a buyer or seller.
The way that you go about your trades can make all the difference in the world in terms of whether or not you will avoid paying the fees. Generally speaking, when you use a market order and accept the current price that an asset is at, you will be matched instantly with a buyer/seller. In this case you will remove liquidity from the market. However, if you were to place a limit order for a purchase of an asset at a lower price than the current ask price, chances are you are adding liquidity to the market. Your order will have to wait until a seller asks for the price that you are willing to purchase at. Once matched, your order will go through without ECN fees being applied. Do you see the potential problem that this could create for you?
Should you always try and avoid ECN fees?
The short answer being not necessarily. Avoiding ECN fees is great, however it depends on how much you will be saving. Is the potential avoidance of paying ECN fees worth the potential opportunity costs involved? Let’s use an example.
Let’s compare if person A were to make a market order and person B creates a limit order. Person A’s limit order is filled at the current price as above of $6.80. Person B’s limit order is set at $6.78. If Person B’s limit order is executed, person B can potentially save the ECN fee of $14.00 as well as gain the difference in the 2 cents. Equating to a total difference saved of $94.00, where $14.00 is saved on ECN fees alone and the $80 is due to the difference in purchase price. This looks great right?
What would happen if person B’s order does not execute? Keep in mind that in index investing we always wish to invest as soon as we have the money. We do not want to time the market by waiting for a potential opportunity.
If the purchase price for the above example goes up to $6.84, there’s reduced chances that the limit order will execute at $6.78. Person B changes their mind and creates a market order cancelling the limit order. The order executes at $6.84. Now person B loses a lot more money. The difference between 4 cents times the amount of shares. This equates to $160. ECN fees in both examples are equal, so we disregard this. Both market order pay the fees.
Is it worth avoiding the ECN fees conclusion?
It is not always worth avoiding the fees. If you really want to get in at the current market price its best to set a limit order that you are confident will go through. Thus you will not lose out should the price increase. However, if you are dead set on getting in to the market at a specific price and you will not get in if the price gets any higher than by far a limit order adding liquidity and avoiding ECN fees is your best bet.