Quantitative Portfolio Management

Chapter 5Trading Costs and Market Elasticity

Trading financial securities involves several types of costs that can be both explicit, such as a broker fee, or implicit. The latter means that the actual trade price ends up different from the market price at the time when the trade is planned. More generally, the cost of a stock trade is the difference between the price paid or received per share traded and a benchmark price. The cost depends on the benchmark definition. Common benchmarks include arrival price, all-day or rest-of-day volume weighted average price (VWAP), or daily closing price. Brokers routinely offer VWAP-tracking execution services. In this context, the cost is the trade price deterioration with respect to the VWAP.

The benchmark price must be consistent across the portfolio management process. The forecast predicts a future price change from the benchmark and thereby an expected profit to be earned on a trade. The cost is subtracted from the profit and thus plays an important role in deciding whether or not the trade is worth the cost.

As we shall see, trading costs are uncertain, just as forecasts are. In an efficient market, the predictability of returns is close to the costs of trading. For a ballpark estimate, one can forecast stock returns at the level of the order of 1 bps per day (Sec. 2.3.3), and the cost of trading is of the same order of magnitude. It takes a better than average skill in both forecasting and execution to keep the difference between ...