What it is:
A commission is a fee paid to an agent as compensation for executing a transaction. It is calculated either as a percentage of the transaction value or as a flat fee.
How it works (Example):
The shares themselves would cost $3,500 ($35 x 100 shares), but the broker would also need to be paid for finding someone to sell the shares to you. For their services, they would charge $70 ($3,500 x 2%). The total cost of the transaction would be $3,500 + $70 = $3,570.
Four months later, you decide to sell your XYZ shares. Now selling at $50, you would receive $5,000 ($50 x 100 shares) from the sale. But once again, the brokerage would take 2% ($100), so the actual proceeds from the transaction would total $4,900 ($5,000 - $100).
Although most investors would calculate the profit on the Company XYZ investment as simply the difference between $5,000 and $3,500 (or $1,500 -- +42.85%), the savvy investor takes commissions into account and knows that the actual profit is $4,900 - $3,570 = $1,330 (or +37.25%).
Why it Matters:
As we demonstrated in the example above, commissions eat into returns and should be considered when making any investment. The Company XYZ investment returned +37.25% after commissions rather than +42.85% -- a full 5.6% of the return went toward paying commissions.
The type of broker you use often dictates the commission you pay. Full-service brokers provide a lot of service in exchange for higher rates. Discount brokers, on the other hand, usually focus on executing trades and do little else. Their clients often pay much lower commissions. In either case, commission structures also vary based on other factors like the size of the client's account, the number or size of trades a client makes, the type of trades a client makes, the kind of account the client has, and whether or not the client buys or sells securities online or over the phone.
It is important for investors to understand their trading preferences when evaluating commission structures. Certain fee schedules may be more beneficial for different types of investors and traders.