The Transaction Tax

In Chapter 14, we look at the Bid/Ask Spread. This is the most important number in trading because it’s the price you pay for Immediacy. If you want to trade right now, you pay the spread. If you’re willing to wait, you try to earn the spread.

The Two Halves of the Spread

Economists split the spread into two components. It’s like looking at a restaurant bill and seeing the “cost of food” vs. the “service charge.”

1. The Transaction Cost Component (The “Transitory” Part)

This is what it costs the dealer to keep the lights on. It covers:

• Clearing and settlement fees.
• Wages for the staff.
• The cost of the money tied up in inventory.
• A little profit for the dealer’s trouble.

When you see the price bouncing back and forth between the bid and the ask ($10.00 -> $10.01 -> $10.00), that’s the Bid/Ask Bounce.

2. The Adverse Selection Component (The “Permanent” Part)

This is the “Smart Money Tax.” As we saw in the last chapter, dealers lose money when they trade with informed pros. To stay in business, they have to charge everyone else a little extra to cover those losses.

This part of the spread is “permanent” because once a pro trades and moves the price, it doesn’t bounce back. The price change reflects new information.

The Most Important Lesson for Retail Traders

If you are an uninformed trader (and let’s be honest, 99.9% of us are), you lose every time you trade.

• Use a Market Order? You pay the wide spread that includes the “Smart Money Tax.”
• Use a Limit Order? You only get filled when you’re on the “wrong” side of a price move. If the stock is about to moon, your limit order won’t get hit. If it’s about to crash, you’ll be the first one to buy it.

Harris’s Advice: If you are uninformed and don’t want to lose, minimize your trading. Trade only when you absolutely have to (like for retirement saving).

The Equilibrium Spread

Why is the spread 1 cent for Apple but 50 cents for a tiny penny stock? In a competitive market, the spread adjusts until traders are indifferent between using a limit order and a market order.

• If the spread is too wide, everyone uses limit orders, and the spread narrows.
• If the spread is too narrow, everyone uses market orders, and the spread widens.

In the next part, we’ll look at the “Secondary Determinants”—the observable things like volume and volatility that actually predict how wide that spread will be.

Next Post: Predicting the Spread (Part 2)