Inside the Black Box: A Simple Guide to Quantitative and High Frequency Trading, 2nd Edition

CHAPTER 5

Transaction Cost Models

Without frugality, none can be rich, and with it, very few would be poor.

—Samuel Johnson

So far we have examined alpha models and risk models, both critical elements of the black box. The alpha model plays the role of the starry-eyed optimist, and the risk model plays the role of the nervous worrier. In this metaphor, transaction cost models would be the frugal accountant.

The idea behind transaction cost models is that it costs money to trade, which means that one should not trade unless there is a very good reason to do so. This is not an overly draconian view of trading costs. Many highly successful quants estimate that their transaction costs eat away between 20 and 50 percent of their returns.

In the world of quant trading, there are only two reasons to make a trade: first, if it improves the odds or magnitude of making money (as indicated by the alpha model), or second, if it reduces the odds or magnitude of losing money (as indicated by the risk model). These reasons, however, are subject to a caveat: A tiny, incremental improvement in the reward or risk prospects of a portfolio might not be sufficient to overcome the cost of trading. In other words, the benefits of the trade need to clear the hurdle of the cost of transacting. Neither the market nor your broker care what the benefits of a trade are. Rather, making a given trade utilizes services that cost the same regardless of the purpose or value the trade holds for the trader. A transaction ...