Transaction Costs & Market Impact: Models & Analysis › Transaction Costs and Market Impact

In the previous chapter on backtesting, we emphasized that a backtest is only as good as its assumptions. Transaction cost assumptions are critical and often underestimated. A strategy that appears highly profitable in a frictionless simulation can become unprofitable or even catastrophic when realistic trading costs are incorporated. This gap between theoretical and realized performance has destroyed countless strategies that looked promising on paper.

Transaction costs represent the difference between the price you expect to trade at and the price you achieve. They arise from multiple sources: explicit fees like commissions and taxes, implicit costs like bid-ask spreads, and market impact from your own trading activity. As a large institutional trader, you may find that market impact alone consumes a significant portion of expected alpha, particularly in less liquid markets or when executing large orders relative to available liquidity.

Modeling transaction costs is essential for strategy evaluation, position sizing, and execution. The relationship between trade size and cost is highly nonlinear: doubling your position size can more than double your transaction costs due to market impact effects. This nonlinearity constrains strategy capacity and scalability.

This chapter categorizes transaction costs, develops mathematical models for market impact, and integrates these models into strategy design and backtesting.