Transaction Cost

Real-life trading performance always lag the returns on paper portfolios, because of a myriad of implicit transaction costs. At Stockfuse, we strive to provide realistic trading performance that can be reproduced in the real world. To that end, we employ a proprietary Transaction Cost Model (also known as Market Impact Model) to dynamically adjust the execution prices of each trade.

Following modern literature, Stockfuse decomposes execution costs into three components:

  1. Instantaneous impact: The market is not frictionless. The price at which buyers are willing to pay (the bid) is always lower than the price at which sellers are willing to receive (the ask). Practically speaking, if you, the investor, buys a stock and then immediately sells it, you’d already lose an amount equaling the spread between the asking price and the bid price. (For more details, please refer to bid/ask.) The cost associated with “spread crossing” is the instantaneous impact. In reality, trades are frequently executed at prices inside the bid/ask, a stylized fact reflected by our model.

  2. Temporary impact: If you buy more than the ask size or sell more then the bid size, then the execution price is highly likely to go against you further; i.e., execution price will be higher than the ask if you’re buying, and execution price will be lower than the bid if you’re selling. Intuitively, if you’re buying a large quantity of a company’s share, the price must be raised in order to attract sellers. This is quantified as the temporary impact.

  3. Permanent impact: This is the final change in the equilibrium price caused by the trade. Intuitively, if you buy a stock, other market participants may perceive your action to indicate that you believe the fair value of the stock should be higher. As a result, the equilibrium price, after the trade has completed, will not return to the original level, but should stay slightly higher.

The inner workings of our model is beyond the scope of this note post, but intuitively:

  • Stocks with larger bid/ask spreads are more costly to trade;
  • If you buy or sell a large quantity of a stock at once, the execution cost tends to be higher;
  • If a stock is illiquid (i.e., trading volume in the market is low), the trade will be expensive;
  • When volatility is high, execution cost tends to be higher as well.