Inside the Black Box: The Simple Truth About Quantitative Trading

5.2. TYPES OF TRANSACTION COST MODELS

There are four basic types of transaction cost models— flat, linear, piecewise-linear, and quadratic—all of which are trying to solve the basic problem of how much it will cost to transact a given trade. Some of these costs are fixed and known—for example, commissions and fees. Models of transaction costs use these fixed costs as a baseline, below which the cost of trading cannot go. Other costs, such as slippage and impact, are variable and cannot be known precisely until they have been incurred. Slippage is affected by a number of factors, such as the volatility of the instrument in question (i.e., the higher the volatility, the greater the expectation of slippage) or its prevailing trend (i.e., the stronger the trend, the more slippage is likely to cost if one attempts to transact in the direction of the trend). Impact also has many drivers, including the size of the order being executed, the amount of liquidity that happens to be available to absorb the order, and imbalances between supply and demand for the instrument at the moment. Traders use transaction cost models in an attempt to develop reasonable expectations for the cost of an order of various sizes for each name they trade.

It is worth mentioning that each instrument has its own unique characteristics based on the investor base that tends to transact in it and the amount of liquidity and volatility present in the instrument over time. GOOG doesn't trade exactly like Amazon (AMZN), ...