It is important to keep in mind that investment advice offered by those who make a commission from each trade may be geared towards encouraging active trading over long-term investment strategies. Be vigilant and critical, and do not let anyone push you or beguile you into making a trade.
A commission broker is someone who gets paid a commission on trades executed on behalf of a client. Many trading platforms employ the same system, where the client pays a commission to the platform for each executed trade.
In both cases, it means that there is a conflict of interest between the client and the broker (or the owner of the trading platform). It can be tempting for the broker to encourage the client to carry out a large number of trades since a client that buys assets and hold on to them for a long time will generate less commission than someone who is constantly buying and selling.
Examples:
- You pay a flat fee of $10 per trade. You buy 100 shares for a total of $10,000 and keep them for a month before selling them. You pay a $10 + $10 commission for that month.
- You pay a flat fee of $10 per trade. You only make small purchases of $100 per purchase, but you make five purchases and four sales during this month. With a total of 9 trades, you pay a total of $90 in commission.
As you can see, the second scenario is more profitable for the broker than the first. This is often true even when commissions are paid based on the number of shares sold or the strike price of a trade instead of a fixed-fee per trade.
Churning
The U.S. Securities and Exchange Commission (SEC) defines churning in the following manner:
“Churning occurs when a broker engages in excessive buying and selling of securities in a customer’s account chiefly to generate commissions that benefit the broker. For churning to occur, the broker must exercise control over the investment decisions in the customer’s account, such as through a formal written discretionary agreement. Frequent in-and-out purchases and sales of securities that don’t appear necessary to fulfill the customer’s investment goals may be evidence of churning.”
Churning can violate SEC Rule 15c1-7 and other securities laws.
SEC is an agency of the United States federal government.
High-commission securities
Some securities may yield a broker a higher commission than others. This will give the broker an incentive to recommend these securities.