Sunday, April 23, 2017

Part 3: 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 there were no cost to waiting, then even the large investors could break up their big trades into smaller lots to reduce the price impact. Even the bid-ask spread could be lower with more patience. Alas, there is a cost to waiting. Which brings us to the third and final part of this Trading Costs series, the opportunity cost of waiting. 

It's an easier concept to understand and think about than the other too. Much more implicit. Damodaran puts it perfectly on page 143 by saying, 

"The price of an asset that in investor wants to buy because he or she believes that it is undervalued may rise while the investor waits to trade..."

There are two very basic things that can happen if the price rises in the time an investor waits to buy. 

1. The purchase price ends up being much higher than expected and greatly cuts into any profits that the investor could have returned.

2. The price rises so much so that it is no longer undervalued and the investor doesn't make any trade thus missing out on the potential profit completely.

For people with long term strategies, the cost of waiting is much lower. Minimal. For the investors focused on the short term the opportunity cost of waiting is much greater.

This one was pretty short because the concept is very self explanatory. If you wait, the cost could move and effect your bottom line from what you wanted at first. Boom. Opportunity cost of waiting.

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