07. Transaction Costs

For institutional traders, the cost is due to the impact a trade has on the market price of the asset being bought or sold.

A “limit order book”, is a list of all the bids and asks for an asset that are made by market participants. Bids are commitments to buy a certain quantity of an asset at a specified price. “Asks”, also called “offers” are promises to sell a certain quantity of the asset at a specified price.

The distance between these two market orders is called the spread, as in the bid-ask spread. The point at the middle of the bid-ask spread is called the midpoint price. The midpoint price is used as benchmark from which to calculate transaction costs.

The midpoint price can serve as the benchmark from which we estimate the transaction cost. For each child order that is traded, the difference between the price paid and this benchmark is a measure of the trade cost, which is called “slippage.”
We can think of slippage as the sum of two kinds of price impact. There’s the temporary price impact, and permanent price impact.