3
$\begingroup$

In equity markets, there are obvious transaction fees such as brokerage, commission fees etc.

But if I wanted to do a more in-depth analysis of the determinants of transaction costs, what would be some key variables to look at? It seems like most analyses focus on liquidity or trade size/volume. But would things such as volatility, yield, credit risk etc be relevant? Or do those only matter to the extent that they affect liquidity?

$\endgroup$
  • $\begingroup$ I would say trading costs comprise of the explicit costs you mentioned plus the spread and market impact, both of which are functions of liquidity. Liquidity in turn could be a function of the factors you mentioned. That's how I see it, I don't have any good references on this, though. $\endgroup$ – MGL Dec 1 '16 at 15:19
  • 1
    $\begingroup$ So you are trying to find out why Goldm@n S@chs makes so much money? ;) $\endgroup$ – noob2 Dec 1 '16 at 16:40
3
$\begingroup$

I would say that an important part of the trading cost is ultimately shaped by the balance of informed (those with private information) and non-informed (liquidy traders) market participants. Imagine a market maker in a market with only non-informed traders that randomly sell att the bid and buy at the ask. The cost for the market maker would be small and she would make money even from a tiny bid-ask spread.

Imagine instead a market with some informed traders. When they know their information would drive up the price above the ask they buy and the market maker will eventually in turn have to buy her inventory back at a higher price realising a loss. In response of course, she will widen her bid-ask spread and perhaps cut back on her volumes.

Not only does this balance shape the trading cost, the mere existence of the market relies on it. The larger the share of informed traders, the wider the spread. And with wider spreads the share of liquidity trades decrease as they shy away from the trading costs. In the end only the most informed traders remain and the market closes.

Such was the fate of the Japanese perp market, analysed in the paper "Liquidity Shocks, Systemic Risk, and Market Collapse: Theory and Application to the Market for Perps".

$\endgroup$
1
$\begingroup$

One other thing to consider is the size of the trade with respect to the volume on a given day. If your simulated trade is larger than the actual volume on that day, then your strategy is unrealistic. You should try running a backtest where you can trade a maximum of 5% of the daily volume, for example. Obviously when trading large ETFs you won't have this problem, but small-cap strategies will often run into this issue. I wrote a blog about trading costs, although it doesn't address the volume side of it. https://rquantceptivity.wordpress.com/2016/12/05/first-blog-post/

$\endgroup$
0
$\begingroup$

It's the covering the cost of giving a price to a client. That's what a trader has to do...

$\endgroup$
0
$\begingroup$

With respect to the implicit trading costs - it would be the following

  1. Spread - higher the spread, more the trading costs.
  2. Your trade size vs market volume over the same period.
  3. Volatility of the stock - for a high vol stock your counterparties would expect a higher premium to provide liquidity to you.

If you want to dig in deeper you can also look at cross impact on similar assets which is less well understood - for example if you trade SPY (the S&P 500 etf) your impact would not be limited to the price of SPY, but also S&P 500 futures and other S&P 500 linked derivatives. Another example might be Ford and GM - similar stocks in the same industry. If you influence the price of Ford by your trading, it would influence the price of GM too.

This paper is a good starting point for the academically oriented.

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.