Trading Costs
Karl B. Diether
Fisher College of Business

Karl B. Diether (Fisher College of Business)

Trading Costs

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Overview of Costs
Trading is costly
Trading costs are usually relatively low in financial markets.
But they still can dramatically affect the profitability of strategies.

Costs
Commissions.
Cannot usually trade at the observed price.
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Bid/Ask spread.
Price impact of trades.

Operational costs (office space, employing traders, etc).
Short-sale costs (more on this later).
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Have to pay extra fees.
Hard to locate shares.
Have to provide collateral.
Sometimes SEC bans short selling.

Karl B. Diether (Fisher College of Business)

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Implementation Shortfall: Paper vs. Reality

On paper
Sometimes strategies that look good on paper are only profitable on
paper because of trading costs.
The difference between the pre-cost hypothetical return and the
actual return earned by a strategy can be huge.

Implementation Shortfall
The difference between the returns on paper (pre-cost return) and the
actual return (after-cost return).

Karl B. Diether (Fisher College of Business)

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Implementation Shortfall: Paper vs. Reality

Trading costs and implementation shortfalls
How can failing to take into account trading costs potentially make
back-testing a strategy misleading?
Which costs (commissions, bid-ask spread, price impact, etc) is the
most likely to cause an implementation shortfall?
Is the cost that is biggest on average the one most likely to produce
an implementation shortfall?

Karl B. Diether (Fisher College of Business)

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Commissions
Commission cost by type
Transaction Method
Online Trading
Automated Telephone
Orders Desk

Commission
max($20 or $0.02 per share)
max($20 or $0.02 per share)
$45 + $0.03 per share

As a percentage of price
The median NYSE stock price during 2007 was $27.88.
0.02
= 0.0007 = 0.07%.
27.88
The median Nasdaq stock price during 2007 was $13.77.
0.02
= 0.0007 = 0.15%.
13.77
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Historical Brokerage Commissions
Average commissions on round-lot transactions in NYSE stocks

source: Jones (2002)

Graph notes
Prior to 1975 commissions were regulated.
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Bid-Ask Spread
Bid price
the price at which a dealer is willing to purchase a given number of shares
(for example: 100 shares).

Ask price
The price at which a dealer will sell a given number of shares.

Bid-Ask spreads in 2005: Diether, Lee and Werner (2005)

NYSE
Nasdaq

Karl B. Diether (Fisher College of Business)

Ask-Bid
dollars
0.031
0.046

(Ask-Bid)/Midquote
%
0.113
0.220

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Historical Bid-Ask Spreads

Average bid-ask spreads in $ for Dow Jones Stocks

source: Jones (2002)

Karl B. Diether (Fisher College of Business)

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Bid-Ask Spread

Questions
Why does the bid-ask spread exist?
Why do Nasdaq stocks have higher spreads on average?
What might cause spreads to be wide?
What might cause spreads to widen?
What type of stocks will have higher spreads on average?

Karl B. Diether (Fisher College of Business)

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Price Impact
No impact
If your trade size is smaller than the posted bid-ask amount, then you
can buy at the ask and sell at the bid.
Sometimes you may be able to trade inside the spread.

Trading large amounts
If you wish to trade a large amount of shares, you may have to trade
outside the bid-ask spread or you may move the spread.
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When you try to sell the price goes down.
When you try to buy the price goes up.

Why might a large trade affect prices?
Why might prices go move or the bid-ask spread widen if you try to sell a
large amount?
Karl B. Diether (Fisher College of Business)

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Managing Price Impact

Order splitting
One solution to price impact is to trade in small increments.
Split your order into pieces so you can trade at or inside the spread.

Downside
Is there any downside to splitting up your orders into small trades?

Karl B. Diether (Fisher College of Business)

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Effective Spreads
Effective spreads
Effective spread (in dollars) = 2*(execution price - midquote)
Effective spread (%) = 2*(execution price - midquote)/midquote
Uses actually execution prices so it should capture price impact.

Bid-Ask and effective spreads in 2005: DLW (2005)

NYSE
Nasdaq

Ask-Bid
dollars
0.031
0.046

Ask−Bid
Midquote

%
0.113
0.220

Effective Spread
dollars
0.027
0.040

Effective Spread
%
0.099
0.199

Is it a problem
Is price impact a problem for a typical trade?
Karl B. Diether (Fisher College of Business)

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Estimating Costs: Bid/Ask Spread

Example
Suppose you bought IBM one month ago and sold it today. The
average price one month ago was $50, and the average price was $60
today. What were the round trip trading costs if the bid/ask spread
was $2 in both cases?
The ask when you bought was $51 and the bid when you sold was
$59. Therefore the round trip trading costs were:
(51 − 50) + (60 − 59) = $2

Karl B. Diether (Fisher College of Business)

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Estimating Costs: Price Impact

Example
Suppose the bid is $49 and the ask is $51 all day (average
price = $50).
Suppose you buy a lot of shares and are forced to pay $52.
The asking price moves to $52, but it is temporary and the ask goes
back down to $51.
In this case the one-way trading costs are,
$52 − $50 = $2.

Karl B. Diether (Fisher College of Business)

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Estimating Total Costs
NYSE: One Way
Total Costs = Commisions + Effective Spreads/2
= 0.07% + 0.099%/2 = 0.12%

Nasdaq: One Way
Total Costs = Commisions + Effective Spreads/2
= 0.15% + 0.199%/2 = 0.25%

Bad estimates?
For what kinds of stocks are these estimate likely to be misleading?
Karl B. Diether (Fisher College of Business)

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Roughly Estimating Costs for a Strategy
Rough estimate for annual returns:
rafter cost = rbefore costs − annual turnover × round-trip trading cost

Example
Suppose your portfolio earned a pre-cost annual return of 15%. The
turnover on your portfolio is 300% annually and the round trip
trading costs are 0.5%. What approximately is the after-cost return?
rafter cost = 15% − (300%)0.5% = 13.5%
Note: turnover equals purchases divided by beginning of the period
assets.

Karl B. Diether (Fisher College of Business)

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Summary

Paper vs reality
Sometimes strategies that look good on paper only are profitable on paper
because of trading costs.

Major costs discussed
Commissions.
Bid/Ask spread.
Price impact of trades.

Total one-way costs
Probably between 0.12% - 0.25% for a typical stock.

Karl B. Diether (Fisher College of Business)

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