There are various costs (apart from the cost of the security) when we trade in the securities markets. These costs can be broadly classified into two groups – ‘Explicit Costs’ which are visible to the traders and appear on transaction documents, ‘Implicit Costs’ which are not visible to the traders.
1. Transaction costs / Usage Costs
These are the costs involved in using the infrastructures of the brokers, stock exchanges, and depositories etc. service providers. Brokers charge brokerage, exchanges charge exchange transaction charges, depository participants pass on the charges by the depositories.
These costs vary from broker to broker and by stock exchanges. The maximum costs are limited by regulations.
2. Statutory Charges
These charges are payable to the statutory authorities in form of Securities Transaction Tax (STT), Service Tax, Stamp Duty, and SEBI Turnover Fees, etc.
You can find these details about these fees and charges in the link provided below.
1. Bid-Ask Spread
A Bid price is a maximum price a buyer is willing to pay for a security.
An Ask price is the minimum price at which a seller is willing to sell a security.
So, an order is executed when the Bid price of the buyer matches the Ask price of the seller. Buyers are sellers do not directly deal with each other but with the market makers who buy securities from the sellers and sell securities to the buyers. Market makers can only make a profit when the price at which they buy the securities is lower than the price at which they sell. That is why the Ask price is higher than the Bid price for the same security. The difference between the best Ask price and best Bid price is called the Bid-Ask spread. The spread is generally dependent on the liquidity and volatility of the security. The spread tends to increase with lower liquidity and higher volatility.
Refer to the attached image. Consider this is the order book for a particular share at a point. Now, you want to buy 100 shares. The best (lowest) ask price is Rs. 6. So, you pay Rs.6 for each share ignoring other costs. Now, if you immediately sell those shares, you will be matched with the best (highest) Bid price of Rs. 5.51. Due to this round-trip, you lost Rs. 0.49 (Rs. 6 - Rs. 5.51) per share which is the Bid-Ask spread.
2. Impact Cost
The concept of Impact Cost is the extension of the concept of the Bid-Ask spread for larger transactions. We can see in the attached order book that the Bid-Ask spread is only limited to 1000 shares.
Consider that you want to do the same round-trip for 3000 shares. As the quantity for the best ask price (Rs. 6) is 2000, your buy order cannot be fulfiled with the best ask price and you will have to pay more for the rest 1000 shares (Rs. 6.12). The weighted average buying cost is Rs. 6.04.
Same goes with the sell order of 3000 shares. You will be matched with 1000 shares at Rs. 5.51, 1000 shares at Rs. 5.21 and 1000 shares at Rs. 5.01. The weighted average selling price is Rs. 5.24.
So, your loss due to the round trip increased to Rs. 0.8 (Rs. 6.04 - Rs. 5.24).
The Impact Cost is defined separately for the buy and sell orders. The calculation of the Impact Cost is based on the ideal price. What is the ideal price? Well, consider in an ideal world of infinite liquidity there is no bid-ask spread- what would the buy or sell price of the security. This can be calculated as the average of the best bid and best ask price. In our example, the Ideas Price is Rs. 5.76 ((Rs. 6 + Rs. 5.51)/2).
Now, to buy order of 3000 shares the actual cost is Rs. 6.04 which is 4.86% higher than the Ideal cost of Rs. 5.76. So, the Impact cost for the buy order of 3000 shares is 4.86%.
For a sell order of 3000 shares, the actual price is Rs. 5.24 which is 9.03% lower than the Ideal Price of Rs. 5.76. So, the Impact Cost for the sell order of 3000 shares is 9.03%.