Transaction Costs
Slippage, spread, commission, and market impact that reduce strategy returns in practice.
Definition
Transaction costs include explicit costs (commission, spread) and implicit costs (slippage, market impact). Total cost per round-trip can be expressed in bps or as a function of size and volatility.
Why it matters
- A strategy with 50 bps round-trip cost and 2% annual turnover has 1% drag; at 100x turnover it has 50% drag.
- High-frequency or mean-reversion strategies are especially sensitive.
Common mistakes
- Assuming zero or flat cost in backtests.
- Ignoring market impact for larger size.
- Using post-trade cost estimates that are too low for live execution.
Best practices
- Use conservative cost assumptions (e.g. 5–10 bps per side for liquid ETFs).
- Stress test strategy at 2x assumed cost.
- Model impact as function of ADV (average daily volume).