"Newbies"

Humor

Themes & Topics

Glossary

Lecture Notes

Trivia & Factoids

Transactions Costs

News
Two studies reported in the L.A. Times on September 13 provide additional support that trading on the Nasdaq is more expensive that the American Stock Exchange (Amex) and the New York Stock Exchange (NYSE).

 In the first study, Chris Muscarella of Pennsylvania State University and Michele LaPlante of Santa Clara University examined block trades -- trades of more than 10,000 shares -- of the 10 largest Nasdaq issues and compared them with similar issues on the New York exchange. They found that the average block trade on the Big Board caused the price to move about 0.18 percent, compared with 0.32 percent on the Nasdaq. The study will be published in the Journal of Financial Economics.

 In a second study, the Plexus Group, a consultant to institutional investors used actual trading records from those clients. They concluded that all the costs of enacting trades for those institutions -- including commissions and market impact -- came to 1 percent for Nasdaq stocks, compared with 0.55 percent for trades on the New York exchange and 0.6 percent for trades on the Amex.

Analysis
I would like to use this news to look at the different sources of costs associated with buying and selling costs, commonly referred to as "transactions costs."

Transaction costs can be divided into three components:

Transactions Costs = bid-ask spread + broker commissions + market impact

Bid-Ask Spread
The difference between the bid and the ask for a security at a given time, where the ask is the highest price anyone wants to pay for the security at a given time, and the bid is the lowest price anyone wants to sell the security for at a given time.

The simplest way to convince yourself that this spread is a cost is to consider the following scenario: you buy a stock, then turn around and sell it immediately. Since these transactions are simultaneous, the actual price of the stock is presumed constant, but you still lose the spread on the transaction. Thus the spread is part of the transaction costs.

Broker Commissions
Whenever you buy or sell stocks, you pay a commission to your broker. This is also true for institutional investors, they have to have a commission too, although it is much less than what an individual pays.

Market Impact
When an investor buys a "large" quantity of shares, she has to pay a price higher than the market price at the time of the purchase. Thus, the investor is said to "move the market," or her trade has an impact on the market prices.

Obviously "large" is a relative term. For a stock on the Nasdaq exchange that does not trade very often, an order to buy a few thousand shares is "large," while for a stock like IBM, an order to buy a million shares is large.

Due to the adverse effect of market impact, large institutional investors tend to spread their orders over a few days or even weeks.

Note that in our story on "Fun and Games on Nasdaq Continue," the major issue was concerning the bid-ask spread, which for the most part had a larger unfavorable impact on small investors. This new evidence, on the other hand, relates to the "market impact" component of transaction costs.

By Alex Tajirian