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Bid/ask (spread)
costs
Spread costs
are the difference between the bid and ask prices for publicly traded
securities. A trader who completes a cycle (buy then sell) in effect is charged
with the spread between the two. Thus, if the market for the
shares of BCE Inc. is $ 29 5 / 8 bid and $ 29 7 / 8 asked a purchase and
immediate resale would cost you 2 / 8 or 84 basis points (0.84%), and a one-way
purchase is likely to cost you half, or 42 basis points. This cost sometimes
exceeds the commission explicitly disclosed on your trade confirmation slip.
Although not shown on the slip it is very real cost.
The average spread on Canadian equities is currently
less than 4 basis points on normal trading
days, and can be much higher in volatile situations; see Mathisson Credit
Suisse 2011 doc.2218, slides 13-15. When you use a discount broker, the bid-ask
spreads can be easily seen when placing an order online, at least for shares. The
cumulative cost of bid-ask spreads increases the more one trades; see
Tradetrek.com.
On the particular case of ETF spreads, see
Nigam 2010 ETF spreads PDF doc.2221. It has been suggested that limit orders should be used to
reduce ETF spread trading costs; see Canadian Couch potato
2012 ETF Pricing
Spreads PDF doc.2215; and Allen 2003 Trading Strategies
For Longer Term
Investors- limit orders PDF doc.2229. See also TradeTrek .
Impact costs
Market
impact costs are the costs incurred when the price of a security changes as a
result of the effort to purchase or sell. The more widely traded a security,
the smaller are the spread and market impact costs. Typically, market impact
costs are small for retail investors trading in actively traded equity securities,
but can be much more significant for equity
securities which trade infrequently, for example small-cap equities, and for many bonds and preferred shares; on
bonds, see Pett NP 2012 Lack of liquidity bonds and
shares PDF doc.2222.
When you use a discount broker, the impact
cost cannot be easily seen when placing an order; however, the discount broker
will sometimes notify you that your order is greater than the current number of
shares being offered for purchase or sale, in effect warning you that the size
of your order may impact the price you can expect to pay.
For
more on this subject for mutual funds, see How much do actively-managed mutual funds cost investors ?
Taxes
Transactions also generate tax costs. The more an
investor trades in his regular, taxable accounts, the greater the tax bill.
Why?
An investor who
never disposed of his investments would never realize capital gains and would
never have to include gains in his tax return. In the real world almost all investors
sell or turn over all or part of their portfolio each year, leading to
potentially important tax costs. When an investor disposes of investments that
have increased in value capital gains taxes are triggered. These gains and the
resulting taxes would have to be incurred in any event eventually but because
of accelerated turnover the taxes become payable at a much earlier time. Low portfolio
turnover is more tax efficient then portfolios that turn over at a high rate.
For more, see for the particular case of mutual funds How much do actively-managed mutual funds cost investors ?
Trading where securities are
sold at a loss is a particular subject. On the one hand intentionally selling
to crystallize a loss for tax purposes can be beneficial; it is called tax-loss harvesting, and is an example
of the advantage an individual investor has by directly investing, rather than
through a fund (funds typically do not practice tax-loss harvesting even though
it could be beneficial to the fund’s investors). But tax-loss harvesting is
rarely the objective of over-trading investors, and if an over-trading investor
does trigger such a loss but repurchases the same securities within a short
period (30 days in Canada and the US) the tax-loss harvesting benefit is lost in
any event. Why? Because tax rules deny the immediate tax deduction normally
available on the original sale (in Canada, this is called a superficial loss). N.B.: the
loss and the resulting tax deduction is eventually recoverable when the repurchased
securities are resold, but a deferral of the ability to claim a loss has a
financial cost to the investor.
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