Transaction Cost Model

In order to calculate the realized returns the total cost needs to be applied first which consists of the broker’s fees and execution cost that is dependent on the liquidity of the stock.

The broker functions as a transaction facilitator between the two parties that are willing to buy and sell a number of shares. The broker practically routes your order into an electronic network and charges a fee for this. In fact, a commission fee is charged both when buying and selling for each party.

A lot of times the broker is charging a fixed fee for each stock regardless of the number of units traded but some other times the commission is a percentage of the trade value that has a dollar amount cap.

Assuming fixed costs and that our trading strategy imposes the trade of 10 stocks, our cost will be the following:

  • Buy order: 10 x fixed fee
  • Sell order: 10 x fixed fee

As a result, the total cost is 20 x fixed fee and the hurdle rate is 20 x fixed fee / invested capital. For a fixed fee of $5 and invested capital of $10,000, the total cost is $100 and the hurdle rate is 1%.

Fortunately, individual investors usually do not have to worry about the execution cost based on the stock’s liquidity. S&P 500 stocks are relatively liquid and the orders are too small to have any impact on the price. Brokerage firms also provide limit order capabilities that can ensure a specific price.

For large trades, you essentially get a volume weighted average price (“VWAP”) since there are multiple blocks utilized to fulfill the order. Also, the order itself applies pressure on the price and a slippage effect is present creating a spiral effect for the effective price.

In conclusion, individual investors can focus on the broker’s fees to estimate their total cost. In general though and for the statistical arbitrage strategies presented in this blog, a transaction cost model of 1 basis point + 1/2 bid-ask spread will typically be used for back-testing purposes.

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