The Old Brokerage House Game: Fleecing the Public by Van K. Tharp, Ph.D.

van tharp bkA note to readers: While Dr. Tharp’s content is timeless, this article is from our newsletter archive and may contain outdated information, missing links or images.

When I look back at my early experiences trading, my perception is that I made every mistake that any of you have ever made and perhaps more.  In fact, I have three early memories of market disasters.  The first is my memory trading Poloron, which I’ve already written about.  I’ve already talked about how everything I seemed to remember now seems as if it were a fabrication of the mind.

My second episode was in graduate school.  My wife and I both had full scholarships.  In addition, I managed some apartment units, so I had no housing costs.  As a result, I managed to accumulate about $20,000 which I remember losing at the bottom of the 1974 bear market.  My memory is that I lost money in 90-95% of the trades.

I also did it again in 1982 (another significant bear market bottom), only this time I discovered that you could go below zero — or at least that’s how I remember it  (at this point, however, I don’t just trust the accuracy of my memory at all).

My assistant recently discovered an old journal of mine in which I had listed trades I’d made from 1971 through 1976.  I actually traded during some great markets.  1971, for example, is the year in which we see the highest all time Market SQN® 100 scores in the S&P 500.

The most interesting aspect of the journal was some old brokerage execution statements that I found.  I am including scans of two of them below.  One was from an options trade and another was from just buying stock.

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In the first trade, I bought 25 shares of Williams Companies for 65-1/4.  So I paid $1,631.25 for my stock.  Now look at the commissions — it was $34.33, 2.1% of the value of the stock.  And this was consistent across positions.  Whether I bought or sold, no matter what the price of the stock, my commissions to enter or exit a trade were a little over 2%.  I also seem to remember that if you didn’t buy a round lot of 100 shares, they also charged an odd lot fee or perhaps another 1/4.  So perhaps my actual cost was $65 per share and the firm added another 25 cents because I was buying an odd lot.  However, there is no evidence for an odd lot fee or how much the bid-ask spread cost me in those days, so we’ll just ignore that part in this discussion.

Nevertheless, it should be enough that it cost me over 4% commission on every transaction (in and out) that I made.  That means after 25 transactions I would have given Merrill Lynch 100% of the value of my account if my account has stayed at the same level.   In other words, I would have doubled my account, but the actual value would have stayed the same and the brokerage company would have gotten the 100% gain.

Now look at the next trade, which represents an option trade.

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Here I sold a call option for 100 shares of Louisiana Pacific Stock.  I sold the call for $425.  And my commissions and fees for doing that were $25.02.  Now we are looking at a transaction fee of 5.89%.  For a call option however, it was pretty much a flat fee of $25 plus change to execute the option.  I only have the one call option statement, but my journal says that the cost to buy was also $25 plus change.

Let’s say that I bought the call of $850 and paid $25.30 in fees to do so.  This would amount to a cost of approximately 3%.  And the in and out fee would be 8.89%.  So with an option trade, I’d have to make about 10% just to make a small profit.

I have two memories of the 1970’s trading.  The first was that I lost on over 90% of my trades.  According to my trading journal, that wasn’t true — I lost on 65% of them.  The second was that my commissions totaled more than my losses.  Well, that obviously was true.  I closed out 31 trades and it cost me on average over 4% for stock trades and probably over 7.5% for option trades. There is no question where the money went.  It really didn’t matter how sharp my trades were.  How many of you clear over 10% on every option trade or over 5% on every stock trade?

When Market Wizards came out in the late 1980s, I made a statement that day trading was a losing game.  Well, in the late 1980s the brokerage game had not changed much.  Commissions actually made day trading a losing game.  I’m not sure that the house odds for the brokerage companies were any better than the house odds at a Las Vegas casino.  And at least in the mob-run casinos of the 1970s you got cheap rooms, meals and entertainment.  Buy and hold almost had to be the stock market game in the 20th Century because of the house odds.

However, the brokerage house game of the 20th century was even more interesting.  In the late 1980s I did some consulting with a Vice President at Dean Witter.  At the time he told me that every month the company put out a list of stock recommendations to their clients.  He said that the only reason a stock ever made it to that recommended list was because it was a stock that the firm wanted to sell.  Thus, by recommending it to their customers, they made sure they had a ready market for the shares they wanted to unload.

My son once had a very active account at a full service broker, but because it was very active his fees were reduced to 1%.  But that’s still 2% to get into and out of a stock.  That means if your risk is 1%, your total risk in a position is actually 3% and you’d have to make 3% just to break even.

Discount Brokers

Charles Schwab became the first discount broker in 1975.  I traded with them once, and I think the commissions were $25.  However, a flat $25 if you were trading large size was still much cheaper than 4%.  If you had a small account, it wasn’t much of a discount at all.

However, today we have eTrade, Ameritrade-Waterhouse, Scottrade, and Interactive Brokers.  And the typical message is that of the eTrade Baby who says, “See, I just bought stock.”

I remember a quote from Daniel Drew in the 1860s.  It went something like, “if you are not an insider, we will fleece you.”   Well now that I’ve looked at the numbers from the primary brokerage houses of the 20th century, the same statement was also true.  2% to get in and 2% to get out is a “golden” fleece.

I thought I would look up some of the old brokerage companies of the 19th century just to see what happened to them.   The table below gives a listing of many of them plus the slogan they presented to the public.

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Perhaps you can get some inkling of the tremendous money game that is played by these institutions.  My suspicion is that charging 4% brokerage fees in the mid 1970s is very minor compared with some of the things that go on behind the scenes.

Anyway, the good news is that most of the things we now teach are possible with today’s discount brokerage community.  For example, on Thursday June 12th, I purchased about $400,000 worth of stock and then sold it an hour later.  Both transactions cost me $7.00 or about 0.002%.  Now you might just purchase $2,000 worth of stock and it would still cost you $7, which is 0.35%, but that’s still a long way away from 2.1%.  So today, short-term trading is a different game.

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