Transaction costs definition
Transaction costs in investing are expenses incurred when buying and selling an asset. There are three types of costs: commissions, slippage and market impact.
One of the most important beginner mistakes when implementing any investments of trading strategies is to neglect or grossly underestimate the effects of transaction costs on a strategy.
There are 3 main types of transaction costs that must be considered:
All investments require some form of access to an exchange, either directly or through a brokerage intermediary (“the broker”). These services incur an incremental cost with each trade, known as commission. Brokerage commissions are often small on per trade basis. Brokers also charge fees, which are costs incurred to clear and settle trades. Taxes are also imposed by regional or national governments (UK applies a stamp duty on equities transactions).
Slippage is the difference in price achieved between the time when a trading system decides to transact and the time when a transaction is actually carried out at an exchange. Slippage is a function of the underlying asset volatility, the latency between the investment strategy and the exchange and the type of strategy being carried out.
An asset with higher volatility is more likely to be moving and so prices between signal and execution can differ substantially.
Market impact is the cost incurred due to supply/demand dynamics of the asset through which they are trying to trade. A large order on an illiquid asset is likely to move the market substantially as the trade will need to access a large component of the current supply.
More illiquid assets are characterized by a larger spread, which is the difference between the current bid and ask prices. This spread is an additional transaction cost associated with any trade.