“Algos” are algorithmic trading strategies that are meant to optimize the execution quality of the trades in terms of transaction costs and market-timing. This chapter presents the transaction costs taxonomy and popular algorithmic execution strategies. Authors empirically examine a dataset of hedge fund transactions. Our results suggest that implicit transaction costs are characterized by a significant buy-sell asymmetry. To get some insight about the possible determinants of Implicit Transaction Costs, authors investigate the algo type and stock characteristics such as market capitalization, relative volume, inverse prior close, price momentum, buy indicator and trade duration. Both in-sample and out-of-sample tests show that a significant portion of transaction costs can be anticipated before the trade execution. Results show that high-level execution strategies can be constructed to optimize the algo choice.
TopTransaction Costs
In market microstructure, liquidity is commonly defined as the ease with which market-users can trade (buy/sell) the asset of exchange, once they decide to do so. For that reason, market-users are typically called the “buy side” of the market – since they “buy” liquidity services, whereas the providers of such services (brokers/dealers/market-makers/standing limit orders) are known as the “Sell side”. Within this context, transaction costs are the premia paid by the “buy side” to the “sell side” as compensation for the liquidity the latter provide.
Transaction costs are divided into two broad categories: Explicit and Implicit costs. Explicit costs are pre-determined, often fixed, and relatively easy to calculate. These include commissions, fees, taxes and bid-ask spreads. Implicit costs, on the other hand are more subtle, and as such they need to be inferred from the observed prices only after making specific assumptions. Implicit costs include investment delay, market impact costs, opportunity costs and market timing costs.
Explicit Transaction Costs
Fixed explicit costs include commissions, fees and tax costs.
Commissions are charged by brokers and are commonly expressed per share or as a percentage of the total transaction value. They are negotiable and vary by broker, fund, trading type or trading difficulty.
Fees are categorized into custodial fees that investors pay to institutions to hold the securities in safekeeping, and transfer fees, which arise when the ownership over a stock is transferred. The latter include clearing and settlement costs, exchange fees, ticket charges and SEC transaction fees.
Tax law commonly stipulates two types of transaction-related taxes. Taxes on short-term and long-term capital gains and taxes on dividends. Generally, tax rates vary by country, investment and type of earnings. Consequently, tax planning is an important concern that must be addressed in investment strategies.
Bid-ask spread is a direct, variable transaction cost and is defined as the difference between the quoted sell and buy price. In theory, the bid-ask spread compensates market-makers for the risks (e.g., funding, adverse selection, counterparty risk) arising from the management of their inventory. Typically, a state of abundant liquidity is associated with small bid-ask spreads.