Liquidity Is a Hidden Trading Cost: Spreads, Volume and Slippage

Commissions went to zero, and many people concluded that trading had become free. The statement encourages the belief. No line item. Nothing to subtract, nothing to notice. What actually happened is that the costs moved somewhere the statement does not look, and the two largest of them are both functions of how easily a stock changes hands.

The spread

Two prices sit behind every quote. The bid is what a buyer will pay and the ask is what a seller will accept, and since you buy at one and sell at the other, the gap between them is crossed twice on every round trip you make. That is the whole mechanism.

Size decides whether that matters. A cent of spread on a $150 large cap rounds to nothing worth discussing. A small cap quoted at $4.00 bid and $4.12 ask costs 3% for the round trip before the price has moved at all, so a trader aiming for a 5% gain on that name has surrendered most of the target before the position even exists.

Nowhere is the spread recorded as a loss. The position merely starts underwater by the width of the gap. That is why a trader who never works the number out can spend years believing the results are breaking even when, taken together, they are steadily behind.

Slippage

Slippage arrives when the order book is thinner than your order. It is the difference between the price you expected and the price you received. The mechanics are simple enough.

Suppose you want 5,000 shares and the ask is showing 800. A market order takes the 800, steps up to the next price, takes what is there, and keeps stepping until the order is complete. Your average fill can end up well above the quote you were looking at. The same thing happens in reverse on the way out, and it happens hardest at the exact moment you most want to be gone, because that is the moment everybody else wants the same thing.

Which side hurts is worth stating plainly. Entry is easy. You are patient, the market is calm, and nothing is forcing your hand. The exit runs on the market’s schedule instead, often in a hurry, at whatever the buyers standing there at that instant are prepared to pay at the time, which in practice is a number you do not get to choose. In a genuinely thin name there may be almost nobody standing there.

Anyone who has tried to sell a large piece of second-hand furniture knows the shape of this. The listed price and the price somebody actually turns up with cash for are two quite different numbers, and the gap widens every week the thing stands in the hall. The asking price is an opinion. The bid is the market.

Where the cost is largest

Small caps first. A few thousand shares can move one of them several percent, which is a cost you pay for the privilege of being early to something nobody else is trading yet.

Options are worse in their own way. Spreads on contracts away from the money, or far from expiry, routinely run to 5% or 10% of the premium, and sometimes a good deal more than that.

Then the sessions outside regular hours, where even the largest names trade thin. And anything you first heard about through a promotion, on the simple ground that the promotion is what produced the volume, and the volume departs when the promotion does.

A worked example

Consider a small-cap strategy. Trade by trade, in a journal kept at mid-prices, it looks profitable. Rebuild the same year using the bid and the ask that were actually quoted at each entry and each exit, and a modest positive expectancy quite commonly falls to somewhere around zero. There was no edge in it. The rules were a method for handing the spread to market makers while the trader felt occupied, and the same rules applied to liquid names frequently come out ahead, which is the whole of the story.

Pricing liquidity into a trade

1. Look at the spread before you look at the chart. Divide the gap by the price. If the round trip costs more than a small fraction of what you are aiming at, the trade is worse than it looks.
2. Set your intended size against average daily volume. A position that amounts to more than a small slice of a normal day will move the price against you on the way out.
3. Add the round-trip spread to risk per share before you size anything. The position size calculator has a fees field for exactly this.
4. Default to limit orders. A market order in a thin stock invites the worst price on offer.
5. Assume nothing about the exit. In a fast market, size the position so that a poor fill remains survivable.

The trading costs guide works through what spreads, slippage and taxes between them remove from a strategy across a year, and penny stocks deals with the extreme end of the range, where liquidity is very nearly the entire problem.