Since You Asked

with Don Bright

Don Bright Portrait

Confused about some aspect of trading? Professional trader Don Bright of Bright Trading (www.stocktrading.com), an equity trading corporation, answers a few of your questions. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.

I keep seeing online discussions of the new, proposed transaction tax. The things I have read make it seem like no big deal, a number around a quarter of 1% for each trade. I can see active traders paying a bit extra, but isn’t this just another cost of doing business? What are your thoughts? — fxguyandgal

Thanks for your insight over the years. I read a discussion of this new transaction tax that is being proposed. Will this have an effect on your traders? My broker hasn’t given us any news regarding this at all. — tradethemall

I have received several inquiries about this proposed transaction tax. The tempo on this tax has picked up since the European community has jumped on the wagon. My friends in the industry think it is inevitable, just a matter of how much, when, and who’s going to be affected.

First, let me demonstrate with some hard dollars. Say you were going to buy and sell 2,000 shares of IBM at around $180 (4,000 shares x $180 = $720,000). As proposed, a quarter of 1% tax would equal $1,800. With many traders, retail and otherwise, hoping to make a full dollar on the trade ($2,000), this tax would nearly put them into the negative column, thus eliminating another market participant (liquidity provider) from the equation. Even if only one side of the trade were taxed, this would be devastating, not only to Wall Street, but to Main Street.

Currently, lawmakers are now talking of lowering the tax to 3/10 of 1%, a much lower number, but still a big negative impact on all traders. Keep in mind that many major market players are trading for pennies.

One of my top traders, writer and market activist Dennis Dick (www.defendtrading.com), has written an excellent article I have been given permission to reprint here. This was first published in the TABB Forum (www.tabbforum.com). Thanks again to Dennis for so clearly explaining the impact on all of us.

Financial Transaction Tax Will Punish Main St., Not Wall St.
Rep. Peter DeFazio is at it again. With support from Sen. Tom Harkin, DeFazio will be introducing a bill to propose a tax on financial transactions.

DeFazio tried to propose a similar tax a couple of years ago but the proposed bill never gained much traction. But now that the European Union has proposed its own financial transaction tax, DeFazio is hoping that his proposal can gain more support.

Their argument is that this tax would generate a substantial amount of revenue at the expense of Wall Street, which can easily bear the tax. But upon closer examination, who does this tax actually punish?

In theory, this tax would raise a substantial amount of revenue. However, it would come with some substantial costs, the most significant being a decline in market liquidity. Market liquidity refers to a stock’s ability to be sold without substantially affecting price.

The majority of our market liquidity is provided by market makers. These market makers (some being high-frequency trading firms) have very small profit margins. A modest transaction tax of 0.03% (which is being proposed) would have drastic effects on the market making business. Let’s take a quick look at the math.

Many of our most highly traded stocks have bid-ask spreads of one cent. A stock that is trading at $25 would have a transaction tax of $0.0075 per share ($25 x 0.0003). If a market maker were to buy this stock at $25 and sell it at $25.01, he would make one cent per share but would have to pay 1.5 cents per share in tax (they have two transactions, the buy and the sell). Therefore, he would lose half a cent on the transaction.

So in order to remain profitable, the market maker would have to widen his spreads to a minimum of two cents and possibly more (as market makers aren’t always profitable on every trade). Wider spreads mean more price impact for institutional traders as they make trades, and this added expense comes right out of the pocket of the individual investor who invests in the fund.

The bottom line is that market makers (some being high-frequency traders) are still going to make money; they are just going to trade with wider spreads to do it. This is an indirect cost to Main Street, not Wall Street.

The direct cost is that the institution transacting would have to pay the transaction tax as well. So another 0.03% comes out of the pocket of the individual investor investing in the fund every time the institution makes a trade. This number may sound small but imagine an institution that trades 200,000 shares of a $50 stock. The transaction fee on that transaction alone would be $3,000. Many actively managed funds trade much higher volume than that in a single day.

These costs would quickly add up, again punishing Main Street.

What would naturally happen is that institutions would become hesitant to trade and may hold on to a position they would otherwise sell just to avoid paying the transaction fee. This, in turn, could lead to large losses in positions that may have otherwise been liquidated. Who would bear the brunt of these indirect costs? Main Street again.

The benefit to this tax would come in the form of the revenue generated from the tax. But trading volumes would drop substantially as traders and institutions seek to avoid excessive taxation. This makes any projected revenue raised by the transaction tax much less than what would be raised on today’s current market volumes. The revenue raised from this tax would pale in comparison to the costs mentioned previously.

Return to Contents