When you trade in Shares, there are some explicit costs. These are charges like Brokerage Charges, Commissions, Taxes, etc. The explicit charges are known and generally planned for while buying or selling Shares. However, there are some implicit costs as well, which are generally not factored in while trading. These includes spreads, market impact cost, opportunity cost, delay cost, etc.
It is critical to understand what these implicit costs are, how to measure them, and then attempt to trade in a matter that reduces these costs.
The explicit costs and implicit costs are collectively called the Transaction Costs.
Why bother about Transaction Costs?
Transaction costs help Investors evaluate how well they and their brokers have executed their trading strategies.
Exchanges are interested in calculating transaction cost to determine how liquid their market is and use this as part of their marketing strategies.
They also help Brokers evaluate their execution performance. It helps them identify better execution strategies and minimise transaction costs.
Regulators too are interested in calculating transaction cost as they help to monitor the performance of exchanges and change policies accordingly to further reduce transaction cost on exchanges.
How to measure Implicit Costs?
There are a number of ways to measure these implicit costs. The only difference among these different ways is the use of the benchmark.
One-way implicit transaction costs have the following general form. It is the summation over all trades executed by a trader of the product, of the size of each trade times the direction of trade times the difference between the trade price and the benchmark at the time of trade.
Number of Units is the number Shares Bought or Sold.
Direction of Trade is 1 if Shares are Bought, -1 if Shares are Sold.
Trade Price is the Price at which the transaction was actually carried out.
Benchmark at the Time of Trade is the Benchmark used to measure the Implicit Cost. The Benchmark is assumed to represent the true value of the stock.
Explanation through an Example
I use an example to explain the various Implicit Costs.
Suppose that the trading days has progresses as follows with respect to one particular Share.
The market opens at 9:30 AM, at which point 15,000 shares of ABC stock trade at Rs. 35.66 a share.
You decide to trade to buy 1,800 shares of ABC at 10:50 AM. The best bid and ask prices at this time are Rs. 36.05 and Rs. 36.08, respectively.
Another trader’s order executes at 11:25 AM at a price of Rs. 36.20 for 850 shares. The best bid and ask prices at this time are Rs. 36.20 and Rs. 36.22, respectively.
At 11:59 AM, 690 shares of your order gets executed at a price of Rs. 36.05. The best bid and ask prices at this time are Rs. 36.20 and Rs. 36.05, respectively.
Another trader’s order for 3,000 shares is executed at 1:16 PM at a price of Rs. 36.15.
At 2:50 PM, another 795 shares of yours are executed at Rs. 36.03. The best bid and ask prices at this time are Rs. 35.99 and Rs. 36.03, respectively.
Finally the market closes at 3:30 PM, when the best bid and ask prices are Rs. 35.91 and Rs. 35.94, respectively.
Assume that there are no other transactions in ABC stock during the day.
Time Weighted Average Price (TWAP) Benchmark
For a stock with N trades in a given day, TWAP is the average transaction price across the N trades.
Decision Point is the Midpoint of the Bid and Ask prices at the time the Investor decides to trade.
In this case, in addition to the difference between the trade price and the benchmark, the Implicit Cost also captures an Opportunity Cost for the part of the order that is not executed. This method is called the Implementation Shortfall Method.
For the above example,
‘Decision time Bid Ask mid-point’ Benchmark = 36.065