What Does it Cost to Buy?

In Chapter 21, Larry Harris explains that the commission you pay your broker is only a tiny part of your total cost. For active or large traders, the Implicit Costs are where the real damage happens.

If you want to be a pro, you have to manage what you can measure.

The Three Components of Cost

1. Explicit Costs: These are easy to see. Commissions, exchange fees, and taxes.
2. Implicit Costs: This is the “market impact.” If you buy 10,000 shares and the price moves from $10.00 to $10.10 while you’re buying, that extra 10 cents per share is an implicit cost.
3. Missed Trade Opportunity Costs: This is the cost of being “too cheap.” If you put in a limit order at $9.95, but the stock moons to $15.00 and you never get filled, you “lost” $5.05 per share by not being aggressive enough.

The Benchmarks: How to Score Your Trade

How do you know if your broker got you a “good” price? You compare it to a benchmark.

1. Effective Spread (The Retail Standard)

You compare your buy price to the midpoint of the bid and ask at the moment you hit the button. If the stock is 10.00 - 10.02 (midpoint 10.01) and you buy at 10.02, your cost is 1 cent. This is great for small orders but misses the point for big ones.

2. VWAP (The Institutional Standard)

Volume-Weighted Average Price. You compare your average price to the average price of every single trade that happened in the market that day.

• The Pro: It’s easy to calculate.
• The Con: It can be “gamed.” A broker can wait until the end of the day to finish your order just to make sure their average matches the market average, even if that wasn’t in your best interest.

3. Implementation Shortfall (The Gold Standard)

This is the big one. You compare your final portfolio value to a “Paper Portfolio” that bought everything at the exact moment you decided to trade. It captures everything: the spread, the market impact, and the cost of the shares you failed to buy. It’s the only measure that can’t really be gamed.

The Problem with “Gaming” the System

Harris warns that brokers will always try to look good on whatever metric you use.

• If you measure them by Effective Spread, they will only use limit orders and never get your trades done if the market is moving fast.
• If you measure them by VWAP, they will just copy the market’s volume profile and ignore the actual value of the stock.

Summary: You Get What You Pay For

Execution quality is a product. If you want a better execution, you usually have to pay more (either in commissions or by being more patient). The key is to use many different benchmarks over thousands of trades to get a true picture of how well you are implementation your strategy.

Next time, we’ll look at Performance Evaluation—how to tell if you’re actually a good trader or just lucky.

Next Post: Performance Evaluation and Prediction