What is Trading cost?

Trading cost is what it costs to buy or sell an investment, on top of the price of the investment itself. The most visible part is the commission, a fee a broker charges per trade, which many brokers now set at zero. A less visible part is the bid-ask spread, the gap between the price buyers are offering (the bid) and the price sellers are asking (the ask). Anyone who buys at the ask and later sells at the bid gives up that gap. Large orders can also push the price against the trader while they are being filled, an effect called market impact. Taxes on gains are usually treated as a separate cost.

Say you hold a $100,000 portfolio and pay a combined 0.1% per trade in spread and fees. Turnover measures how much of a portfolio is traded in a year. If you buy and sell $50,000 worth of investments in a year, a turnover of 50%, the cost is $50,000 × 0.1% = $50, or 0.05% of the portfolio. If you trade $400,000 in a year, a turnover of 400%, the cost is $400,000 × 0.1% = $400, or 0.4%. Over 30 years that gap compounds. $100,000 growing at a hypothetical 7% a year becomes about $761,000, while the same money growing at 6.6% a year becomes about $680,000. A cost that looked small each year ends up at roughly $81,000.

A common misunderstanding is that zero commission means free trading. The spread is still there, and it is wider for small companies, for less traded funds and for many cryptocurrencies, and it tends to widen during sell-offs, when many investors want to trade at once. Trading costs in a backtest (a hypothetical test of a strategy on past data) are assumptions. A backtest that leaves them out, or assumes them too low, can show hypothetical results that no real investor could have achieved.

For a private investor building a long-term portfolio, trading cost is one of the few things within direct control, alongside fund fees. The annual fees of the large S&P 500 funds VOO, SPY and IVV are 0.03% to 0.09%, so an approach that trades often can spend more on trading than on the fund fee itself. Investors comparing approaches therefore look at how often each one trades, at how liquid the investments are, and at whether the expected benefit of each trade outweighs its cost.

By Dr. Harry Hamann

Is zero-commission trading free?
No. Removing the commission takes away only one part of the cost. Buyers still pay the ask price and sellers receive the bid price, so the spread between the two remains a cost on every round trip, and market impact can add to it on large orders.

What is a bid-ask spread?
It is the difference between the highest price a buyer is offering (the bid) and the lowest price a seller will accept (the ask). For large, heavily traded funds the spread is usually tiny. For thinly traded assets it can be much wider.

How much do trading costs reduce returns?
It depends on how much is traded and on the cost per trade. In a hypothetical example, 0.1% per trade costs 0.05% a year at 50% turnover but 0.4% a year at 400% turnover. Over decades, compounding makes the gap much larger.

Are taxes part of trading cost?
Usually not. Trading cost normally covers commissions, spreads and market impact. Taxes on realised gains depend on the investor's country and account type, so they are often counted separately, although they can be a large cost of frequent trading in taxable accounts.