Wednesday, April 19, 2017

Part 2: True Costs of Trading

As stated in the book "Investment Philosophies" by: Aswath Damodaran (recommend), there are three main sources that contribute to trading costs. 
1. The bid-ask spread
2. The price impact
3. The opportunity cost of waiting. 
the source of the following information is from the book listed above. 

If you are an investor who deals solely in large to mega cap stocks, or securities with a very high average volume then this cost will likely be irrelevant to you. If you have similar views as I do, and you believe that the small cap stocks are the ones that are more likely irrationally/inefficiently underpriced, then price impact could make a difference in your bottom line investment. 

Most investors, myself included, believed that as the portfolio grew and investments became larger, the costs went down. Like going to Costco and buying in bulk and getting everything cheaper. Economies of scale. But, sometimes the large investments can drastically change the purchase or selling price of the investment. Making larger block trades can increase the bid-ask spread. Ex: If someone is looking to buy 10,000 shares, someone needs to be willing to sell that many shares. In order to persuade another to do so, they'll want to sell for a higher price for their troubles and increase the buying price. The major cost difference from large traders to small traders however, is price impact. Damodaran states in his book, 

If the basic idea behind successful investing is to buy low and sell high, pushing the price up as you buy and then down as you sell reduces the profits from investing.

The basic idea of price impact is that when buying shares, your buying volume is pushing the price up and when selling you push the price down. The problem is that once the price is pushed in either direction, it will come back to normal soon.

There are a couple main reasons why this happens. The first is liquidity. If you are making a large trade, (think about buying a low priced, small cap stock with very low volume/ low liquidity) you "can create an imbalance between buy and sell orders, and the only way in which the imbalance can be resolved is with a price change." Once the bulk trade is completed the price impact will reverse once the liquidity is returned to normal.

The other idea revolves around information and herd mentality. If there is an order for a huge block trade, other investors will take notice. The typical thought is that the trade is because they know of good news and the price will continue to rise. That the first investor knows something no one else does. In this case, the price impact won't be fleeting and the inflated/deflated price could be propped up by the extra liquidity from herd mentality.

Thought the evidence to back this up on a larger scale is not the best, it definitley happens. Not as much with mid cap and up where the price impact is smaller and quicker to reverse, but with the smaller ones. I can provide some examples as well as my own troubles with it. 

A couple of my friends and I decided to invest $50 each into a penny stock. It was priced at $0.31 so we were buying roughly 450 shares. After the purchase, I checked the chart on and saw a bump in the price. Similar to what you see here. 

Look at the line on Tuesday, April 18th and the volume spikes below it. You can see from 1pm to 3pm there was either nothing or trades of about 100. At about 10am you can see the price spike up and the volume do the same. That's the price impact at work. Here are some other examples with low priced, low volume stocks spiking from price impact. Here is a perfect example.

I hovered over the huge jump today to show you the volume. Under the zoom options for different chart lengths is the volume at that time. At 9:54, there was a huge spike in volume of 34.34 thousand shares. That's 34,340. With such a big block trade investors likely thought there was good news and the price has continue to grow. If you look to Tuesday, the spike at 10am was 8,000 shares and then from that trade until 3pm there were no trades placed. With low volume comes high price impact.

Like I said earlier, this trading costs may not even effect you. If you're going after large cap, high volume, "popular" stocks, then price impact won't make a difference in your bottom line. If you are an investor looking for mispricing and market inefficiencies in small cap, lower volume stocks, then be careful. Buying will be more expensive and selling will be at a lower price. By how much is unknown, but it is still a cost to trading. 

Part 3 of 3 coming soon.

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