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Transaction Cost Analysis (TCA)

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Transaction Cost Analysis (TCA):
What is it, and how can it help your financial investment strategy?

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What Is Trade Slippage?

Trading slippage is the difference between the expected price for a trade and the price of that trade at the moment of execution. As such, slippage can happen when buying or selling a ‘security’, which can refer to any type of fungible financial instrument(1), such as stocks, bonds, or currency. 

Key Points

    • Trading slippage is the difference between the expected price of a trade and the price the trade goes for.
    • Trading slippage can happen both when buying and selling. It can also refer to profits and losses.
    • A transaction cost analysis can only be undertaken using specific software. Microsoft Excel won’t help you here.
    • Trade calculation analysis solutions exist, but they tend to have an exorbitant price tag. Our software isn’t created from scratch, so it’s more affordable.

How Does Trading Slippage Work?

What is considered positive or negative slippage changes depending on your role in the trade.

When you’re the buyer:

  • Positive slippage denotes that the price of the security has gone down in value from the moment you decided to make that purchase (i.e. you pay less for that security); and
  • Negative slippage means the price has increased (i.e. you pay more).

When you’re the seller, the definitions of positive and negative slippage are inverted. 

  • Positive slippage means the price has increased; and
  • Negative slippage means the price has gone down.

Obviously, no slippage signifies that the price has remained the same in both cases.

Why Does Trading Slippage Happen?

When an order is executed, a security is bought or sold at the most advantageous price offered by the liquidity provider or exchange at that exact moment. So, what this means is that the price you actually pay or sell for can be different from the price you were initially quoted.

This tends to happen for two main reasons:

  1. High Market Volatility: When the price of a security increases or decreases quickly over a short period, leading to higher risks.
  2. Low Liquidity: When both the number of buyers and the number of sellers for a particular security are small, each trade will affect the price of the security as a whole.

Both these scenarios can affect the bid and asking prices of trade and, therefore, determine your trading slippage.

Trading Cost and Slippage Summary

Examples of Trading Slippage In Action

Markets and exchanges operate faster today than they did in the past. This is mainly due to the rise in electronic trading, which is the buying and selling of investment and financial instruments over the internet. Indeed, as The Economist announced back in 2019, ‘the stock market is now run by computers, algorithms, and passive managers’(2)

What this means for trading slippage is that market volatility and liquidity can change in a matter of hours or even minutes. This is especially so following an announcement by a market influencer on Twitter, a piece of breaking news, or simply because many brokers use trading idea automation to make trades on their behalf based on their specific parameters.

Here are three recent, real-life situations when a buyer or seller may have experienced trading slippage and a short explanation of what happened.

  • Price of Dogecoin Up 50% [4 February 2021]: On the day Elon Musk, the co-founder and CEO of Tesla and the world’s richest man(3), tweeted, saying that ‘Dogecoin is the people’s crypto’, its price rose by 50%(4) over 24 hours. This mainly happened because the volume of trading for Dogecoin tripled.
  • Amazon Stock Prices Collapse [29 April 2022]: When Amazon reported an unexpected loss of $3.8 billion in the first quarter of 2022, its stocks crashed by 14%(5) in a day, wiping $206.2 billion off the stock market. This seemed to be due to a lack of confidence in the global e-commerce giant, which led to many sellers trading with a small number of buyers. Even so, analysts from the Bank of America have said that these losses should be manageable(6) for the company.
  • Massive Drop In Dow Jones Industrial Average [6 February 2018]: In February of 2018, DJIA stocks lost 800 points in ten minutes(7), leading it to practically crash. Many financial experts believe that this was caused by trading robots, which sold these stocks en masse following a report on the US job market.

These examples show us that trading slippage can result from many reasons, some of which we don’t always have control over.

How Can Trading Slippage Costs Be Avoided?

As we’ve discussed, trading slippage costs can never be wholly avoided. They are part of the financial market game, and investors have to make some allowances for them whether they are buying or selling.

More importantly, even negative slippage costs aren’t always the worst-case scenario, especially when the price you pay for a security, though higher than what you anticipated, is still lower than the security’s current value.

Nevertheless, it pays to manage these costs in both the long- and the short-run. Here is our advice on doing so.

  • Understand How Your Provider Treats Slippage: Some brokers may sell or purchase securities on your behalf regardless of whether you’ll incur a slippage cost or how much that slippage cost will be. As such, asking your provider to explain their procedure in case of general slippage costs is the first step in knowing where you stand.
  • Enforce A Limit Order: A limit order is a set instruction to your broker or financial manager to only purchase or sell a security at a specific price or for one that further benefits you. While this cannot be ironclad – the price of a security may change in the moments it takes to press a button – it can help avoid most negative slippage.
  • Enforce A Stop-Loss Order: A stop-loss order is similar to a limit order, but in this case, you will agree to a sell or purchase a security given your losses won’t exceed a certain percentage, say 10%. Once again, this is not guaranteed to work all the time, but it can help limit your negative slippage if stop-price range is managed.
  • Do Not Trade During Certain Periods: Buying or selling a company’s stocks right before or after a big announcement or a piece of breaking news will lead to higher risks, which can result in higher slippage costs. Sometimes this may be favourable to you, but you can never be sure of that until the trade has been concluded. To stay on top of this, gradually create a securities calendar where you note down significant dates (planned announcements, end-of-year or quarterly report release dates, etc.) and avoid trading on those securities at any such time.
  • Look For Low-Volatility Markets: Low-volatility markets are those whose prices increase or decrease at a slower and steadier rate. This means that the price you sell or buy a security for should be close to the one you anticipated. An example of this would be investing in gold rather than cryptocurrencies, the latter of which can crash or soar in a matter of hours.
  • Only Trade When The Markets Are Open: Liquidity refers to how quickly a security can be bought or sold, thus keeping the slippage costs to a minimum. To make the most of this, avoid submitting trade requests overnight or throughout the weekend, as these will end up in proverbial limbo until the markets reopen, at which point, the security price can change drastically due to breaking news or other factors. Similarly, it’s good to understand how specific markets work. For example, while the foreign exchange (forex) market is open 24 hours a day from 5 pm on Sunday to 4 pm on Friday, the most significant volume of trades usually happens when the London Stock Exchange is available for trading, which is Monday to Friday from 8 am to 4.30 pm GMT(8).
  • Conduct a Transaction Cost Analysis: Finally, you should invest in software that can perform transaction cost analysis, also referred to as trade or trading slippage analysis. This helps you keep track of a security’s price history and allows you to compare them with the market volatility at the time of execution. We explore this in further detail just below.

Why is a Transaction Cost Analysis undertaken?

When it comes to trading, you can incur considerable costs along the way. Some, like the commission paid to brokers or exchanges, can easily be calculated and applied to a trade ahead of placing an order. Others, like those incurred due to mistakes in financial statements from your bank or broker, are harder to manage. Still, they can be picked up through automated statement processing software and, therefore, avoided.

Trading slippage costs are a different kettle of fish entirely. Firstly, they can neither be looked at as fees nor as given mistakes. Secondly, they can sometimes be a welcome occurrence and, at others, a costly surprise.

This is because trading slippage is connected to the quality of your trade executions. So our experience, knowledge, and timing all play a crucial role in helping us avoid, limit, or use them to our best advantage.To help us on this quest, we can employ the help of trading slippage reporting processing software. Through it, we can outline the correlation between market volatility, liquidity, and forces with how these affect the order execution of the trading strategy.

The Functions of a Trading Slippage Reporting Processing Software

A trading slippage analysis is nothing more than a slippage monitoring programme through which you can compare the price you wanted to sell or buy for with the one you actually sold or bought for. But for such a process to be successful, investors cannot look at slippage as a number in a vacuum. After all, knowing you paid x-amount more on a hundred securities doesn’t tell you much about why it happened and how it can be avoided.

That’s why such an analysis should be used as an opportunity to back-test our strategy for buying or selling specific securities at a particular time, on a specific date, for a particular price, and during specific circumstances. That explains where our expectations and reality diverged, helping us finetune our strategy for future purchases.

So, in other words, a good trading slippage analysis needs to track the price from order generation to execution by:

  • Monitoring the market price and liquidity evolution during the lifecycle of an order;
  • Grouping data from multiple accounts by period, instrument, asset class, or any other category of your choosing;
  • Running the necessary calculations to identify slippage costs and strategy success; and
  • Creating understandable reports in different levels of detail to be distributed amongst the team so that everyone can stay in the loop.

With this information accumulated through such an analysis, we can then attune our strategy for future events, allowing us to anticipate risks, manage slippage, and hopefully be more successful in our endeavours. But, of course, no human being can do that in an age when trades happen at lightning speed, which is why dedicated software is essential here.

Transaction Cost Analysis Solution: Why Is It Needed?

To conduct a proper slippage analysis, you require specific Trade Cost Analysis (TCA) solutions. In other words, Microsoft Excel just won’t cut it here.

But why is that so?

The answer lies in the sheer amount of data that needs to be collected for each security. This includes the expected price, the actual price it was traded for, the market volatility and liquidity before and at the time of the trade, and the market forces at play at the time of execution.

This gets even more convoluted when you consider that you probably effect hundreds of trades per week, resulting in a barrage of information that is practically impossible to compile without the proper software. But even then, we are still not considering the fact that you may use different venues or brokers to sell or buy securities.Moreover, when all this is collected, this data needs to be grouped, analysed, and aggregated before you can use it in your investment strategies.

Transaction Cost Analysis Software: The Good & The Bad

TCA solutions can do all of the above, yet many investors still don’t conduct trade slippage analysis. If you’re wondering why that is, the answer is in the balance between the pros and cons of using such solutions.

Advantages

Using TCA solutions to help you manage your slippage comes with some obvious yet undeniable advantages. As we have seen above, such software can help you to

  • Automatically compile and aggregate the vast amounts of data generated through your sales and purchases of securities;
  • Keep tabs on your trading slippage through reports;
  • Get a better understanding of when and where your strategy faltered; and
  • Use this goldmine of information to attune your strategy to current market forces.

Disadvantages

The pros here often get investors excited, but the three main disadvantages of using TCA solutions still tip the scales, particularly for small-to-medium enterprises (SMEs). Here’s why.

  • Cost: Such software tends to be extremely expensive, running into the tens or even hundreds of thousands of euros per year. This is because most TCA solutions are connected to large databases where the information on market volatility, liquidity, and forces is stored.
  • Time: Transaction Cost Analysis solutions run heavy calculations, which means you’ll sometimes have to wait hours for your report to be completed. Moreover, TCA solutions on the more affordable side of the spectrum do not even allow intraday reporting; only end-of-day ones. This may defeat the purpose of some trade slippage analyses, which could be used to help you make decisions in real-time.
  • Expertise: Adding to this, most Transaction Cost Analysis software requires in-house developers and programmers to programme and operate the system. This further adds to the cost and strain on your resources.

Final Remarks on Trade Slippage Software

If you’re in charge of a large financial corporation, then you probably have the resources needed to undertake a successful trade slippage analysis, and you should definitely invest in such a system. But we don’t want to close off without a word of advice for SMEs.

There are alternatives to the TCA software mentioned above, and they’re affordable and come with outsourced experts to help you learn from your trade slippage and boost your strategy. We, of course, are talking about our tailored solutions that combine strategy automation, data analysis, and predictive modelling to let you measure your slippage costs, predict what may happen in the market, and update your strategy to limit slippage accordingly.

So, are you ready to turn slippage costs into an opportunity to better your strategy?

SOURCES:

Wakett comprises a team of experts from the financial and software fields. Our articles are based on experience and expertise, as well as primary and secondary sources.

(1) Kenton, W. (n.d.). Security. [online] Investopedia. Available at: https://www.investopedia.com/terms/s/security.asp#:~:text=Securities%20are%20fungible%20and%20tradable. [Accessed 29 Apr. 2022]

(2) The Economist. (2019). The stockmarket is now run by computers, algorithms and passive managers. [online] Available at: https://www.economist.com/briefing/2019/10/05/the-stockmarket-is-now-run-by-computers-algorithms-and-passive-managers. [Accessed 1 May 2022]

(3) Haverstock, E. (n.d.). Elon Musk, Nearing $300 Billion Fortune, Is The Richest Person In History. [online] Forbes. Available at: https://www.forbes.com/sites/elizahaverstock/2021/10/26/elon-musk-nearing-300-billion-fortune-is-the-richest-person-in-history/?sh=4ba8b6581933. [Accessed 30 Apr. 2022]

(4) The Guardian. (2021). Price of dogecoin rises by 50% following Elon Musk tweet. [online] Available at: https://www.theguardian.com/business/2021/feb/04/price-of-dogecoin-rises-by-50-following-elon-musk-tweet. [Accessed 01 May 2022]

(5) Amazon’s Biggest Drop Since 2006 Caps Miserable Month for Tech. (2022). Bloomberg.com. [online] 29 Apr. Available at: https://www.bloomberg.com/news/articles/2022-04-29/amazon-s-biggest-drop-since-2014-caps-miserable-month-for-tech [Accessed 2 May 2022]

(6) Ponciano, J. (n.d.). Amazon Stock Erases $210 Billion In One Day After Inflation Triggers Surprise Loss And ‘Ugly’ Selloff. [online] Forbes. Available at: https://www.forbes.com/sites/jonathanponciano/2022/04/29/amazon-stock-erases-210-billion-in-one-day-after-inflation-triggers-surprise-loss-and-ugly-selloff/ [Accessed 29 Apr. 2022]

(7) Did robot algorithms trigger market plunge? (2018). BBC News. [online] 6 Feb. Available at: https://www.bbc.com/news/business-42959755. [Accessed 1 May 2022]

(8) www.lseg.com. (n.d.). FAQs. [online] Available at: https://www.londonstockexchange.com/personal-investing/faqs?accordionId=0-87cc6e10-b537-4fc8-9f19-7d5994ce1e52. [Accessed 30 Apr. 2022]

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