This document discusses modeling transaction costs for algorithmic trading strategies. It presents a taxonomy of explicit costs like commissions, fees, and taxes as well as opportunity costs and benchmark slippage. Two methods are described for estimating slippage: equation-based models and simulating child order fills. The appropriate method depends on the strategy's timescale. The document provides guidelines for keeping transaction cost modeling simple while still accounting for costs accurately. It emphasizes considering costs early in the strategy development process.
5. Factors that Drive Slippage
Small Orders: Large Orders:
slippage is
primarily due to
market impact
slippage is
primarily due to
spread
Price Action
affects all orders
+
luck
𝛼 decay
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11. Method B: Simulate Fills
1. Generate stream of child orders: { time, size }
2. Generate stream of simulated fills: { size, price }
3. Avg Price = VWAP of fills
Ability to create child orders
Tick data
Limit order model
Market order model
Impact memory function
Requirementssizei x pricei
sizei
∑i
∑i
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12. Defining Strategy Timescale
Strategy Holding Period
milliseconds seconds minutes hours days weeks months
Intraday
Alpha
HP = minutes to hours
Expected profit: ≤1 x spread
Alpha decay = fast
Trading concern: ‘gas pedal’
High Frequency
Trading
HP = milliseconds to minutes
Expected profit: .05 -.10 ¢
Alpha decay = immediate
Trading concern: latency
Low Frequency
Quant
HP = days to months
Expected profit: ≥1%
Alpha decay = slow
Trading concern: liquidity
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13. Slippage Model Selection
Low Freq
Method A (simulate parent order fills)
Use the data you have available
Be conservative
Intraday
Method B (simulate child order fills)
Bring execution algo into backtest
...or break into 2 step process
HFT
Method B+ (simulate direct order fills)
Incorporate Level 2 data
Incumbents may find it easier to live-test
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14. Keeping It Simple
Focusing on ‘slippage-safe’ strategies
1. Avoid strategies that are overly cost-sensitive:
intraday holding periods
expected paper PNL ≤ 2 x spread
only profitable with optimistic cost assumptions
rapid alpha decay
2. Stick to a liquid stock universe
3. Cap order sizes (≤ 25% 1-minute participation rate)
4. Assume at least a minute to execute orders
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15. Explicit Costs (US Equities)
Broker
Commission
Taxes & Fees
Ticket Charges
TOTAL (1-way)
.05 - .20 cents
+ net fees (.06¢)
0.5 - 1.0 cents
~.05 cents included
NA $1+ (or NA)
.15 - .30 cents 1 cent + tickets
Low FreqIntradayHFT
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16. Opportunity Cost
timedecision
price
price limit
}+25 bps
Opportunity cost: effect of unexecuted shares on PNL
If you plan to trade with price limits or conditional
execution strategies, backtest accordingly
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17. Golden Rules
1. Think about transaction costs early and often
2. A simple cost framework is fine as long as you make
conservative assumptions and “stay on the path”
3. To run more cost-sensitive strategies, be prepared to
invest in a more sophisticated t-cost framework
4. Account for all three kinds of transaction costs
5. Backtest at full scale
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