Learning Outcomes
After reading this article, you will be able to explain how the bid-ask spread, market impact, and slippage create trading costs for investors in financial markets. You will be able to distinguish between explicit and implicit transaction costs, calculate the bid-ask spread, assess market impact, and identify practical examples and methods to minimize trading cost components—critical for the CFA exam.
CFA Level 3 Syllabus
For CFA Level 3, you are required to understand how transactions costs affect trade execution and portfolio performance. Specifically, you should be able to:
- Describe the components of transaction costs, distinguishing between explicit and implicit costs
- Explain how the bid-ask spread is computed and decomposed into primary sources
- Identify the effects of market impact and slippage on realized trade prices
- Evaluate and compare the effects of trading strategies and execution methods on overall trading costs
- Apply transaction cost analysis to evaluate best execution and cost minimization
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What are the two main sources of implicit trading costs in financial markets?
- How is the quoted bid-ask spread calculated, and what are its main components?
- Define market impact and explain how it differs from slippage.
- If a buy order for 10,000 shares is executed in multiple trades, each at a higher price, what type of cost is being observed?
Introduction
Efficient portfolio management and performance assessment require a clear understanding of trading costs in real-world markets. The difference between what an investor wants to transact at and the final net result often comes down to microstructure effects—specifically, the bid-ask spread, market impact, and slippage.
These costs—some visible, others less obvious—affect realized investment performance and are essential for trade strategy selection and best execution. This article examines how each cost arises, how to measure them, and practical implications for exam candidates.
Transaction Cost Components: Explicit vs Implicit Costs
A trading desk faces both direct and indirect costs when executing orders.
Key Term: explicit transaction cost
The visible, easily-measured costs of trading, such as commissions, exchange fees, and taxes.Key Term: implicit transaction cost
The hidden costs of trading—comprising the bid-ask spread, market impact, and slippage—that are realized through price movement or execution conditions.
Bid-Ask Spread and Its Decomposition
When a security is traded, buyers pay the ask (offer) while sellers receive the bid.
Key Term: bid-ask spread
The difference between the lowest offer price (ask) and highest price a buyer will pay (bid) for a security at a given moment.
The size of the spread is affected by:
- Order processing costs (dealer compensation)
- Inventory risks faced by liquidity providers
- Adverse selection (risk that the counterparty has superior information)
Bid-ask spreads may be quoted as an absolute difference or as a percentage of the mid-price: Bid-ask spread = Ask price – Bid price Spread % = (Ask – Bid) / Midpoint
Market Impact and Slippage
Large or impatient trades move prices as liquidity is consumed.
Key Term: market impact
The price movement caused directly by a participant’s own trade, as their order absorbs available liquidity.Key Term: slippage
The gap between the average price actually achieved on a trade and the price at the time the order was initiated.
These effects are typically more pronounced for large orders, illiquid stocks, or when urgency forces traders to cross the spread multiple times, walking the book.
Worked Example 1.1
A fund manager wants to buy 15,000 shares of SmallCap Ltd, showing a best bid of $41.90 and an ask of $42.10. The manager submits a buy order for 15,000 shares, filling:
- 4,000 at $42.10
- 6,000 at $42.20
- 5,000 at $42.40
Answer:
The average price paid is higher than the initial ask ($42.10). The manager paid up to $42.40 due to the market impact of absorbing available liquidity, and the additional cost over the initial ask is recorded as market impact and slippage.
Sources of the Bid-Ask Spread
Liquidity providers (dealers or market makers) quote spreads to compensate for risk and effort. The spread includes:
- Processing costs (administration, technology)
- Inventory risk premium (price fluctuation during inventory holding)
- Adverse selection (risk of trading against more informed or urgent counterparties)
During times of high volatility or low liquidity, dealers widen spreads to manage these risks. In active, large-cap stocks, competition and high turnover result in tighter spreads.
Worked Example 1.2
The best quoted bid for a bond is $99.80. The best ask is $100.00. A client wants to buy and then immediately sell 500 bonds.
- What is the round-trip transaction cost per bond?
Answer:
The round-trip spread per bond is $0.20. The investor pays $100.00 to buy and could only sell at $99.80, losing $0.20 for each bond round-trip before any external fees.
Market Impact: Order Size and Execution Urgency
Market impact depends on:
- Order size relative to average daily volume
- Market depth and liquidity (number of orders at best prices)
- Execution urgency (market vs limit order)
Traders minimize market impact by breaking orders into smaller pieces, using limit orders, or executing over longer periods. However, excessive order breaking can lead to information leakage and adverse price drift.
Worked Example 1.3
A trader must sell 50,000 shares of a thinly-traded stock. They place market orders in blocks of 2,500 shares each over the day, causing the price to fall with each execution.
- What cost is this trader incurring?
Answer:
Each block pushes the price down, so the trader observes negative price movement due to their own actions—market impact is the realized cost of each block transacted below the initial price.
Slippage Calculation
Slippage can be measured relative to:
- The last traded price before the order was submitted (“arrival price”)
- The average expected execution price
- A benchmark price (such as VWAP, Volume Weighted Average Price)
Slippage is positive for more favorable executions and negative (a cost) when trades are filled at less advantageous prices.
Exam Warning
A common misunderstanding is to consider only explicit trading costs when analyzing transaction efficiency. Implicit costs from market impact and slippage often exceed commissions, especially for large or illiquid trades. Always account for both in CFA exam calculations and written responses.
Minimizing Transaction Costs in Practice
Traders and portfolio managers may:
- Use limit orders instead of market orders when possible
- Break larger trades into smaller lots (order slicing or algorithms)
- Schedule trades during periods of high liquidity
- Seek liquidity providers or dark pools with tighter spreads
However, these strategies may introduce the risk of partial execution or opportunity cost if price moves away during execution.
Summary
Bid-ask spreads, market impact, and slippage together represent the major, often hidden, trading costs faced by investors. Understanding each component, their source, and methods of measurement and minimization is essential for achieving best execution. For the CFA exam, you must be able to decompose and evaluate all transaction cost components and apply that analysis to calculations and strategy decisions.
Key Point Checklist
This article has covered the following key knowledge points:
- Define explicit and implicit transaction costs and distinguish between them
- Calculate the bid-ask spread and identify main risk sources for liquidity providers
- Explain market impact and its relation to trade size, execution style, and urgency
- Describe slippage and calculate it relative to benchmarks for actual trades
- Evaluate practical methods to minimize bid-ask spread, market impact, and slippage
- Analyze how cumulative trading costs can affect portfolio performance
Key Terms and Concepts
- explicit transaction cost
- implicit transaction cost
- bid-ask spread
- market impact
- slippage