Low Initial Investment + Frequent Trading = A Disaster

As you might be aware, I’m not a high frequency trader.  I have my positions.  I try to stay in the positions for at least a year.  I’ll take a profit (or take a loss) if appreciation and circumstance seems right.

Trading with little money is destined to lead to failure.  I don’t need experience to teach me this lesson, just a simple understanding of trading fees, the tax code and a sense of reasonable expectations.

An example will be the most effective way to communicate this point.

Let’s say I have an account with $1,000 and I want to put $270 on a stock that I think has a lot of potential to increase in value within the next year.  My trading account charges $7 per trade.

If my purchase price is $6 per share, I can buy 45 shares for $270 (270/6 = 45 shares).  My trading expense will be $7, which will equate to 2.6% of the value of my investment.  I now have my 45 share investment and I’ve spent $277 of my account’s funds.

A few months pass and the investment I have is now selling for $8.50.  I decide to sell.  I thus have made a $2.50 profit per share, which equates to $112.50 increase in my account’s value (45 shares * $2.50 = $112.50).  I incur another trading fee of $7 from this trade.

Where do I stand after making this trade?

My gain from the stock = $112.50 or +41.7% from my initial investment of $270.  The trade was within a year, so I’m going to have the gain taxed at the rate at which my income is taxed.  For sake of example, let’s say it’s 30%.

$112.50 * 30% = $33.75 taxes to be paid.

I’ve also incurred $14 in trading fees.

$112.50 – ($33.75 + $14.00) = $64.75 after tax and commission profit.

$64.75/$112.50 = 57.5%…Of the dollar value gain I booked, only 57.5% of that is actually mine to keep as profit.  Nearly half of the value of my return has been taken away.

If we divided $64.75 by $270, we see that the ROI is now slightly less than 24%.

The fact that your initial investment is so small makes your margin for error extremely thin.  The $14 trading fee incurred from entry and exit is so significant that you get hit from both sides when trading.  Your trading fee takes a chunk and taxes take another larger chunk of your money.

In this example we saw an impressive short-term gain nearly cut in half from trading fees and taxes.  If the return was less on the investment it would have been even worse.

Being a successful trader is a steep enough task, it does not need the additional burden of a minuscule initial investment.