Wednesday, April 12, 2017

Part 1: True Costs of Trading

This blog is meant to provide you with more information on trading costs. Most retail investors don't understand what goes into trading costs. When I first started, the only cost to me was the commission set by the broker to buy the number of shares. $4.95. This is the only cost you'll explicitly pay, but there are more that come up over time. The more I do this and the more I learn, the more I realize how uninformed I really was.

Most research that is out on stocks or funds or anything showing the return of something is usually before trading costs. Basically, what the return would have been on paper. If you take into account the trading costs - what is called the trading cost drag - the realized return is significantly smaller. The basic equation used when finding the return of an active money manager is Expected Return + return from active trading - trading costs. If you read my previous post then active management means a little more to you. 

Back in the late 70's and into the 90's Value Line was a firm that offered trading advice to individual investors. Similar to Zacks, they ranked the stocks 1 through 5. After a few years of following their picks, they realized the higher raters equaled a higher return, almost without fail. The annual return of a mock portfolio of their picks earned 26.2% annually. In 1979, Value Line created a mutual find that went through with the firms picks. It was disappointing because when the trading costs were taken into account, the portfolio only returned 16.1%. The trading costs accounted for a 10% decrease in return.

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. 

Bid-Ask Spread
With each trade there is a buyer and a seller. In all cases, there is a difference in the buying price and selling price and is changing with the stock price. As an example, we'll look at three different companies and three drastically different market caps. For each example I'll provide the cost of only the bid-ask spread as a percentage of buying 1 share and selling one share.

Buy at the $113.13 puts you back 0.01% and selling at 113.10 takes away 0.02%. The spread here makes nearly no difference.

Buy at the $51.26 puts you back 0.19% and selling at 51.19 takes away 0.06% from your return. A lower price and a higher percentage lost.

Buy at the 3.78 puts you back 0.53% and selling at 3.74 takes away 0.53%. The smallest price with the largest percentage toward your portfolio.

Thankfully with the advances in technology the bid-ask spread has gone down to cost much less than it used to. The use of automation has been able to lower the price and keep costs lower for investors like you and I. Each of those stocks above have a high average volume and still a higher market cap. This next one has low volume and very small market cap. The spread here is considerably larger.

Buying a stock here would immediately set you back roughly 4%! Unless the stock is very well known, it may behove you to check the bid-ask spread to make sure it doesn't set you in a huge hole. If you were to go through with this trade and buy 5 shares for $28.10 while including the trading costs it would cost $145.45 (28.1 x 5 + 4.95) and you'd be in a hole by 7.7%. THEN, when you take into account the $4.95 cost to sell the shares, it would end up being down 11.40%. The break even share price would be $30.08. THAT's when you need to take a look at trading costs.

I took this picture of one of the charts in Damodaran's book that shows the relationship between price and spread.

How it works. You own 10 shares of XYZ priced at $20.00 after buying at $16.00. The bid ask spread for this stock is $21.00 and $19.00. You see that XYZ reached $20 dollars and want to capitalize on the gain. You go to Mr. Market to sell and, based on the bid-ask spread, can sell for $19.00 per share. If the trading cost is $4.95, and you just lost $10 dollars from having to sell at $19 instead of $20, then that equates to a loss of 5.89% off total return. Instead of getting a 17.72% percent profit, you'll get 11.83%

The basic rule of thumb as a small retail investor is you sell at the lower price and buy at the higher price. The bid-ask spread is ever changing and can vary widely between different stocks. Above is a larger cap, a mid cap, and a small cap stock. Besides the size of the company, there is a difference in average trade volume on a given day as well. When a stock is traded as much as Intel - 15 million times a day - the bid ask spread will be tiny. Barely even making a dent in the costs. As the average volume drops, processing costs come into play. For ever transaction, there is a fixed cost associated with holding the inventory and processing the trade. For large block of trades by institutions, this will be pretty small. For smaller companies with smaller trades, such as an investor buying 8 shares, the cost is higher. The bid-ask spread has to cover these costs creating a wider gap between the stock price and the price you'll actually pay. 

Here is an excerpt from page 131 of Mr. Damodaran's book ----
"A bid-ask spread of 10 cents is trivial on a stock priced at $100 but substantial on a stock priced at $2. Not surprisingly, the bid-ask spread stated as a percentage cost tends to be higher for lower-priced stocks. Going back to the variables that underlie the bid-ask spread, the fixed processing costs will also tend to increase (in percentage terms) as the price level on a stock drops. The price level is a factor in almost every asset market, but it tends to play a bigger role in creating differences in transaction costs in markets where prices vary widely across assets."

The next post I write will include the price impact, and the opportunity cost of waiting. Stay tuned!

No comments:

Post a Comment