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7 Things to Watch Out for With Zero-Commission Trades

'Free' isn't exactly free in this case

financial analyst looking at money screens

B Busco/Getty Images

En español | Recently, Charles Schwab, E*Trade and TD Ameritrade all announced they will offer zero-commission online trades for stocks, exchange traded funds (ETFs) and options. I suspect that others, like Fidelity, will follow. These discount brokers will be offering the ultimate discount — free! I remember buying my first stock as a child, and the commission was 5 percent.

While I think this is generally good for consumers, there are a few things to watch out for.

  • This doesn't eliminate trading costs. Every stock and ETF has a different price for buyers and sellers. This is known as the bid-ask spread. It can be very small or much larger for stocks or ETFs that don't trade frequently. In fact, Michael Lewis’ book Flash Boys describes how some firms build high-speed networks to make a fortune from those spreads.
  • "Free” may make you more likely to trade. Many studies have demonstrated that investors who trade more have lower returns. That's because it's human nature to buy a security that's hot and sell one that's not. Indeed, we underperform the market by poor timing. Men underperform women overall because of higher trading.

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  • Taxes are fees, too. More frequent trading can lead to higher capital gains taxes. Those additional taxes are likely to be far higher than the $4.95 a trade ($6.95 for TD Ameritrade) you saved before those fees were eliminated.
  • Some pay little on cash. Many online brokerage accounts have cash go into what they call a default account that pays very little. So they may pay you less than 0.5 percent annually when you have the opportunity to earn nearly 2 percent elsewhere. That lost interest is yet another hidden fee. Some brokerage firms make more money from your cash than they do on commissions.
  • Just say no to stock options. In the aggregate, not a penny has ever been made in stock options. If you buy a call, someone has sold it to you and the two of you will net zero. No commissions on options merely makes options trading a slightly less bad thing to do.
  • Mutual fund trades may not be free. While some firms offer certain funds without commissions, they generally (but not always) tend to be ones that have higher fees.
  • There is no free lunch. Schwab, TD Ameritrade and E*Trade are publicly held for-profit companies. They aren't offering free trades merely to help investors; these are likely a loss leader to capture more in the way of consumer assets and then sell more expensive products or charge ongoing fees to manage your portfolio. It should be noted, however, that Wall Street doesn't think this is a profitable tactic, as stocks for all three companies fell sharply after the announcement.

My view is that fee wars are good for consumers and I'm glad to see fee compression continue — both in the way of lower trading costs and fund fees. With Fidelity's introduction of zero-cost mutual funds last year, fees for both have now hit zero.

Remember that investing is about minimizing expenses and emotions. Though it's now pretty easy to minimize expenses, free trades could lead to more emotional mistakes.

Allan Roth is the founder of Wealth Logic, an hourly based financial planning firm in Colorado Springs, Colorado. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.