Lesson 6 of 10
Trading in stocks involves certain cost with are commonly known as trading costs. These courses are made up of the commission or the brokerage fees paid to the broker, and the bid-offer spread. In case of large transactions there is an additional cost known as market impact. This is because executing a large transaction may move the price from the originally quoted price.
The trading costs are important from the return perspective and also from the perspective of the arbitrageurs as high transaction costs make negate the viability of an arbitrage opportunity.
Let us discuss these costs in detail.
A commission or brokerage fees is the fee paid by a client to the broker for buying and selling shares on his behalf.
This fee is generally negotiable and depends on the size and volume of the trade and also on the level of service expected. It could be calculated as a percentage of the total transaction value.
The commission covers expenses for the broker such as transaction fees paid to the stock exchange, order-handling fees, etc.
The full-service brokerage firms generally charge the highest fees and commissions. Discount brokerage firms offer reduced commissions. Commissions are discounted even more at deep discount brokerage firms.
The difference in commissions and fees is due to the level of service provided by the broker. For example, full-service broker provides a full range of services including personal advice and financial research. A discount broker may not provide advice but may or may not provide free research. Some discount brokers may charge for research information. A deep discount firms will generally provide no-frills execution-only service
The rates may be even lower in case of orders placed via internet, which is the cheapest method.
The bid-offer spread is the difference between the prices a broker/dealer is ready to buy the stock and the price at which he is ready to sell the stock.
The size of the spread reflects the liquidity position of the stock, as less liquid stocks will tend to have high bid-ask spread. Therefore, under competitive conditions the bid-ask spread measures the cost of making a trade without delay.
Typical bid-offer spreads in large liquidity stocks are about 0.5-1.0 %.
When people buy and sell stocks, it adds new information in the market, which has an impact on the market price of securities. If all other factors remain the same, buying stocks will increase their market price.
So, in case of a very large trade, where the stock is illiquid, the price at which the trade is executed will be higher than the indicated price. This is due to the market impact.
Market impact is a function of the market depth at the time of execution, an will vary with time and stock. Estimating market impact is a complex task.