Transaction Costs and Turnover
A strategy that returns 15% a year in a backtest may have nothing left after fees and slippage. The more you trade, the more costs eat.
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Text version · Quant Basics, lesson 6: “Transaction Costs and Turnover”
A strategy that returns 15% a year in a backtest may have nothing left after fees and slippage. The more you trade, the more costs eat.
Every trade pays a toll
Commissions, spread, slippage, and taxes and fees together make up the transaction cost. Annual cost ≈ turnover × one-way cost × 2.
Breakeven cost
The one-way cost that brings net return to zero = gross return ÷ (turnover × 2). The higher the turnover, the smaller this number and the more sensitive the strategy is to costs. Underestimate costs a little in a backtest and the conclusion can flip completely.
Costs aren't just commissions
Half the spread, slippage, and taxes and fees all count as one-way costs. The bigger the order and the less traded the market, the bigger the slippage. In a backtest, it's better to overestimate costs a little.
Key takeaways
- Annual cost ≈ annual turnover × cost per side × 2 (one buy and one sell).
- Cost per side isn't just commission; it also includes half the spread, slippage and taxes.
- High-frequency strategies are extremely sensitive to costs: slightly higher costs can turn a winner into a loser.
- Judge strategies by net return after costs, and work out the "breakeven cost" that would bring net return to zero.
Try it yourself
You can do these exercises in this lesson's interactive simulation:
- Pick “Swing trading”: the gross return is 15%. How much is left after costs?
- Pick “Day trading”: the gross return is 30%, so why is the net return negative? What's the breakeven cost?
- Pick “Long-term holding” and raise the one-way cost to the maximum 0.50%: how much net return is left?
- Pick “Swing trading” (one-way cost 0.20%) and find the turnover that makes net return exactly 0.
Quiz and explanations
- 1. Gross return is 10%, annual turnover is 20 times and cost per side is 0.2%. Roughly what's the net return?
- Answer: 2%.20 × 0.2% × 2 = 8%, and 10% − 8% = 2%.
- 2. For the same gross return, the higher the turnover, the breakeven cost will be…
- Answer: Lower.The more you trade, the less cost each trade can bear.
- 3. Gross return is 12% and cost per side is 0.1%. At what annual turnover does net return hit zero?
- Answer: 60 times.Each turnover costs 0.1% × 2 = 0.2%; 12% ÷ 0.2% = 60 times.
Terms in this lesson
- slippage (Slippage): The difference between the price you expected and your actual average fill, which happens when a large market order eats through several price levels.
- spread (Spread): The gap between the Ask and the Bid, a hidden cost on every trade.
- transaction cost (Transaction Cost): Commissions, stamp duty, spreads and slippage: the costs you pay on every trade.
- turnover (Turnover): How many times the portfolio's value is traded in a year; the higher the turnover, the higher the trading costs.