# CHAPTER 2

# Potential Profit and Transaction Costs

**P**ardo's algorithm for evaluating potential profit includes even the tiniest price changes and uses them to his advantage. These small price changes can be profitable because it assumes that transaction costs are zero. In real life, transaction costs can turn winning trades into losing ones. A price change should be large enough to compensate for all costs and still net a profit. Transaction costs are an important factor that influence trading decisions and change the number of profitable trades, their distribution in time, and the size of the profit. An algorithm for evaluating potential profit when costs are taken into account becomes more complicated. In this chapter, I analyze the properties of the potential profit strategy we began in Chapter 1 and introduce some notions necessary for building an algorithm to generate that strategy. The algorithm itself will be constructed in the next chapter.

## WHAT IS A TRADING STRATEGY?

There are several definitions of *trading strategy*. At the time of this writing, Wikipedia (the free encyclopedia available on the Internet) contains an article with the definition: “a Trading Strategy is a predefined set of rules to apply.” This can be extended to be a *set of rules that are followed in a precise order when deciding whether to enter or exit a trade*. At any moment, for a given market the application of the strategy must clearly result in whether we should be holding a long or short position as ...