Impact Of Transaction Costs

Transaction costs are the greatest deterrent to day-trading profits. The failure to execute near the intended price, plus the commission costs, can remove a large part of potential profitability and even turrrexpected profits into losses. An aspiring day trader has two ways of improving performance: by paying lower commissions and by careful selection of opportunities. Table 16-1 presents the percentage relationship of moderate transaction costs to the maximum daily price move. The average dollar volatility for the years 1990 through 1996 is shown next to the percentage represented by a $100 transaction cost. In general, $ 100 is a modest value for the combination of commissions and slippage, and traders would be very pleased to extract an average profit of one-half the daily volatility. A practical approach would therefore use twice the percentage effect of a $100 cost shown here.

Realistically, a day trader would choose the index markets, more volatile currencies, and long-term interest rates as their best opportunity for profits. Corn represents the least desirable market because very low volatility leaves more risk than opportunity. Although a $ 100 transaction cost may seem high for this market, a $20 commission and slippage equal to a minimum move of *M, or $12.50, totaling $45, would be the smallest possible costs. An occasional fast move in the market, based on unexpected economic news, or large orders entering at one time, must result in a larger number, raising the average.

To keep dollar volatility of a futures contract to a level acceptable by most traders, exchanges have been forced to resize contracts, specifically stock index markets, as overall share values have climbed. During 1997, the S&P was reduced from $500 per basis point to $250, and the FTSE-100 from £25 to ¿10. In 1998, the French CAC40 contract was cut to 25% of its previous size. This increases the relative size of transaction costs.


The importance of liquidity is magnified in day trading. Execution slippage of $100, measured as the difference between the system price, or Market Order price, and the actual filled price, will have litde impact on a month-long trade netting $2,000; however, it will be criticaTfor a day trade with a profit objective of under $300. The selection of day-trading candidates begins with those markets of greater volume. Whether one contract or 1,000, a

TABLE 16-1 Volatility and Liquidity, U.S. Markets, 1990-1996

Market fVolatility %$I00

Cotton 540 18.5

Corn 163 61.3

Soybeans 405 24.7

Australian dollar 353 28.3

British pound 848 11.8

Canadian dollar — 291 34.4

Deucschemark 703 14.2

Japanese yen 869 11.5

Swiss franc 975 ~ 10.3

High-grade copper 421'' 23.8

Crude oil 454 22.0

Heating oil 513 19.3

NYSE Composite 1,144 8.7

Treasury bills 160 62.5

Treasury notes 568 17.6

Treasury bonds 764 13.1

thinly traded market produces slippage that will cut sharply into profits. In choosing among index markets that usually offer the greatest volatility and profit potential, you are always safest with the markets that combine the highest volume and highest volatility.

Occasionally, markets with light volume show larger price moves than similar markets traded on other exchanges. Traders will be tempted to profit from these moves but will consistently find that the execution of an order at the posted price is elusive. The reality of trading these markets is that a Market Order is not advisable due to the thinness of the trading, a Limit Order may not get filled, and a spread is not quoted at anything resembling the apparent price relationships that you see on a quote screen; there is no real way to take advantage of these perceived profits. If an execution succeeds, exiting the position still has the same problems plus some added urgency.

Missed Orders

Because the profit objective, projected daily range, holding time, and end-of-day constraints all put limits on a day trade, there are situations in which the market jumps after a news release and you cannot get filled anywhere close to your intended price. With most of the potential profit gone before you enter the order, it would not be surprising to simply skip that trade. These missed orders, called unables, can add up to a large part of your profits; at the same time they never reduce your losses.

Some markets are prone to more unables. For the energy complex, heated military or political activity in the Mid-East can cause a prolonged period of very erratic price movement, resulting in as much as 20% unexecuted trades during a 1-month period. If we consider the normal profile of a short-term trading system as having an average net profit of $250, an average loss of $150, and a 50% frequency of profits, we expect a profit of $5,000 for every 100 trades and a reasonable profit-to-loss ratio of 1.66. If, however, there are 10% unables, that missed opportunity must come from the profits; if the market was moving in the opposite way, you would get all of your positions filled. Then 10% of the profitable trades means 5 trades out of every 100 for a total of $1,250 missed. This reduces the total profits to $4,750 and the profit factor to 1.50. It may turn a marginal trading strategy, or one with small profits per trade, from a profit to a loss.

Price Ranges

The average daily range (not the true range) shows the maximum potential for a single day-trading profit. Some markets, such as gold and corn, combine a lack of liquidity with a narrow daily range and are easily disqualified from a day trade opportunity. Eurodollars have extremely high volume but very little movement; therefore, they are also not a good candidate for day trading. When volume is combined with volatility, the world index markets, followed by the currencies and long-term interest rates, are shown to be the best choices. Energy markets represent the next tier, grains remain active, and other markets have far lower volume.

Day uraders may find that those markets with traditional daily trading limits present a problem during high-volatility periods. Day trading does best in markets "that have wide swings not deterred by exchange limits; a single locked-limit move can generate a loss that offsets many profitable day trades. High volatility and locked-limit moves present a contradiction for day trading. Rules that provide for expanding limits have greatly helped reduce the frequency of locked-limit days; however, traders must always be on guard for this situation.

Estimating Slippage Costs

If you know the cost of slippage, you can do a much better job selecting the markets to trade and have a realistic appraisal of your trading expectations. The factors that make up slippage are volatility, overall market volume, current market activity, and the size of the order being placed. Of these items, current market activity is the most difficult to record, because it requires some estimation of volume as it accumulates throughout the day. While actual volume is not available for most markets, a reasonable approximation can be made using tick volume, the number of price changes during a fixed interval. In general, tick volume is directly proportional to actual trading volume; during periods of greater activity, both contract or share volume will increase along with the number of price changes.

If you have carefully recorded the order price, execution price, volatility (daily high -low), daily volume, time of day, and tick volume, you can find the importance of each factor and estimate the slippage for any trade by applying the model:

Actual slippage at time T= a0 + «1 x volatility + az x daily volume +

i?3 x current activity at time T + a4x size of order

By creating a spreadsheet of values for all trades, you can solve for a0, alt a2, and a4, and then estimate future slippage at any time T during the day, given the current volume and order size. This approach was taken in 19921 for large Stop orders using a ratio of order size to current market activity. The results, shown in Table 16-2, show that slippage was very modest for most markets. The far right column gives the slippage likely at the 5% level; that is, there is only a 5% chance of having slippage greater than $13,5 per contract for sugar, combining both entry and exit. Commissions were not included. The unusually large "worst" loss in Treasury bills was confirmed as correct.

Price Level

Continuing volatility is most common in markets that are at abnormally high price levels. Bull markets are followed by bear markets, and the combination creates sustained activity. Prices that are volatile at low levels are most likely to be at the end of a decline and can be returning to previous, less volatile patterns. The agricultural markets, when carryover

' Thomas V Greer, B. Wade Brorsen, and Shi-Miin Liu, "Slippage Costs of a Large Technical Trader," Technical Analysis of Stocks & Commodities 0anuary 1992).

TABLE 16-2 Slippage (Loss) for Stop Orders (Slippage in Dollars per Contract)*

5% Chance

__of Worse than

TABLE 16-2 Slippage (Loss) for Stop Orders (Slippage in Dollars per Contract)*

5% Chance

__of Worse than





St Dev

on Entire Trade

World sugar

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  • manlio gallo
    How Transactions cost effect technical analysis?
    1 month ago

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