The 5% Rule: What it is, how it works and examples

Adam Hayes, PhD, CFA, is a financial writer with more than 15 years of derivatives trading experience on Wall Street. In addition to his extensive derivatives trading experience, Adam is an expert in economics and behavioural finance. Adam holds a Master's degree in Economics from the New School for Social Research and a PhD in Sociology from the University of Wisconsin-Madison. He is a Chartered Financial Analyst (CFA), holds FINRA licences 7, 55 and 63, and currently researches and teaches economic sociology and financial sociology at the Hebrew University of Jerusalem.

What is the 5% rule

The Five Percent Rule is a rule issued by the Financial Industry Regulatory Authority (FINRA), the agency responsible for regulating brokers and brokerage firms in the United States. The rule, adopted in 1943, states that brokers cannot charge more than 5% commissions, markups, or margin on common trades. Routine transactions include quoted and over-the-counter trades, as well as commodity sales and risk-free transactions.

Although the 5% rule is also known as the 5% margin policy or 5% margin policy, it is more of a guideline than an actual regulation. Its purpose is to require brokers to use fair and ethical practices when setting commissions so that the price an investor pays is reasonably related to the market price of the securities being purchased.

Key aspects to be aware of

The five per cent rule, also known as the five per cent markup rule, is a Financial Industry Regulatory Authority (FINRA) guideline that recommends brokers charge no more than five per cent of commissions per transaction.

The five per cent rule is a recommendation, not an actual regulation, and is designed to ensure that investors pay reasonable commissions and that brokers set their fees on an ethical basis.

Certain persons or securities may not be regulated by FINRA and therefore may not be subject to the Five Percent Rule. In an investment context, the 5% rule may also mean that no single security or asset may comprise more than 5% of a portfolio.

How the 5% rule works

The 5% Rule does not set any standards for calculating commissions or fees. Instead, it sets guidelines for brokers to follow. The rule applies to a variety of transactions, including.

• Principal trades: A broker buys or sells securities from its own inventory and receives a commission or fee for the trade;
• Proxy trading: The broker acts as an intermediary and receives a commission on the trade;
• Product Trading: A broker sells a security to a customer and uses the proceeds to purchase another security. The broker sells a product to the client and then sells it to another broker;
• Riskless Trading: In this type of simultaneous trading, a company buys securities from its own inventory and immediately sells them to a customer.

There are a few exceptions to this rule. For example, the rule does not apply to securities that are sold through a prospectus, such as in a public offering. According to FINRA, "The Board has revised the rule several times, each time reaffirming the philosophy articulated in 1943."

How reasonable fees are determined

If the purpose of Rule 5% is to establish reasonable fees, a natural question arises: How does a firm determine what is fair? The following factors are considered in determining a fair and reasonable commission

The price of the underlying security

• The total value of the transaction (large transactions may benefit from a lower commission);
• The type of security (e.g., options and equity trades have higher commissions than bonds);
• The total cost of the participant's services;
• The cost of executing the trade (some companies require a minimum trade size).

It is important to note that each of the above factors can result in higher or lower commissions than 5%; commissions can be much lower than 5% for simple and large equity trades and much higher than 5% for small and complex securities trades with lower trading volume.

Example of the 5% rule

If a customer wants to buy 100 shares of a hypothetical company at 10 dollar per share, the total transaction value is 1,000 dollars. If the broker's minimum transaction value is 100 dollar, the total commission will be 10% of the transaction amount, which is much higher than the 5% rule. However, if the customer knows the minimum transaction value in advance, this rule does not apply.

Special considerations

The 5% rule has another meaning as well. From an investment perspective, it can mean that no more than 5% of a portfolio should be allocated to a single security - in other words, the aggregate holdings of mutual fund shares, company shares or even industry shares should not exceed 5% of an investor's total assets. This rule was not established by any investment agency; it is simply a general rule of thumb to guide investment decisions.

The 5% rule is a benchmark that helps investors diversify and manage risk. Under this strategy, no more than 1/20th of an investor's portfolio can be invested in a single stock, avoiding significant losses in the event of a company's underperformance or bankruptcy.

Which shares are not protected by the 5% premium policy

All shares issued under the prospectus are not covered by the 5% premium policy. In fact, all commissions and fees are stated in the prospectus. The same applies to open-ended investment funds or securities offerings.

Who is exempt from FCA rules

Certain individuals are exempt from FCA rules. Exempt from FINRA registration are persons whose functions are administrative/executive in nature, limited partners, or persons involved in transactions that are executed only on an exchange.

How the 5% policy was developed

FINRA's Board of Directors adopted the policy in 1943 in response to feedback from transacting customers. In general, most transaction-based research is conducted with a rate of return of 5% or less.

The Financial Industry Regulatory Authority (FINRA), which regulates brokers and brokerage firms in the United States, established a requirement known as the "5% rule." This rule, which dates back to 1943, states that commissions, margins and spreads on normal transactions (including exchange and over-the-counter quotes, cash sales and risk-free transactions) must not exceed 5%.