QQ 201, 2 min read

Costs

After this lesson you can

Name the four costs of a trade
Compare cost with average profit per trade
Stress test a strategy's cost assumptions

A strategy's edge is what is left after costs. Many strategies that look good before costs have nothing after them.

The four costs

Spread. You buy at the ask and sell at the bid. Every round trip pays the gap.

Commission. A fee per trade, charged by the broker or exchange.

Slippage. The difference between the price you expected and the price you got. It grows with order size and with how fast the market is moving.

Financing. Interest on a position held overnight, called swap in foreign exchange. Short holding periods barely notice it. Positions held for weeks do.

Why frequency matters

Costs and profit are both counted per trade, so the comparison that matters is cost against average profit per trade.

Suppose a strategy averages 6 dollars profit per trade before costs, and a round trip costs 4 dollars. Two thirds of the edge is gone. If the real cost is 7 dollars, the strategy loses money.

A strategy that trades ten times a day needs a far larger edge per trade, relative to cost, than one that trades once a month.

Stress testing

You do not know your future costs exactly. So instead of one assumption, test several: double the spread, add slippage, fill every order one bar late. A strategy worth trading still makes money under the harsher assumptions. One that is profitable only at the most favourable one should not be traded.

The terminal's execution checks rerun a strategy with a spread, with slippage scaled to volatility, with delayed fills and with financing, and report how much of the profit survives. The details are in Fills and costs.

Key points

The edge is what is left after costs
High-frequency strategies need a larger edge relative to cost
A strategy that only works at the kindest cost assumption has no edge

Check your understanding

A strategy averages 5 dollars per trade before costs. A round trip costs 5 dollars. What is its edge?
Which strategy is most sensitive to an error in the cost assumption?