BFF2701 Chap.4 Liquidity and Trading Costs
Liquidity and Trading Costs
Liquidity has several dimensions. Tightness concerns the cost of a small immediate trade, depth concerns available quantity near the best prices, immediacy concerns how quickly a desired trade can occur, and resilience concerns how quickly prices and depth recover after an order imbalance. A venue can score well on one dimension and poorly on another, so turnover alone is not enough.
The quoted spread is best ask minus best bid; dividing by the midpoint makes it comparable across price levels. The effective spread uses the actual trade price relative to the prevailing midpoint and therefore measures realised execution cost. A trade inside the displayed quotes can have a smaller effective spread than the quoted spread.
Large orders may also pay price impact by consuming depth, while delayed or unexecuted orders create opportunity cost. Explicit costs such as commissions and fees must be combined with implicit costs such as spread, impact and timing. A complete execution analysis chooses a benchmark, keeps units consistent and links the number to the relevant liquidity dimension.
What this chapter covers
- 01
Tightness, depth, immediacy and resilience
- 02
Liquidity supply and demand
- 03
Quoted and relative spreads
- 04
Effective spread
- 05
Market depth and price impact
- 06
Explicit and implicit trading costs
- 07
Execution benchmarks
Worked example · free
Compare displayed and realised trading cost
- +1Midpoint = ($24.90 + $25.10) divided by 2 = $25.00.
- +1Quoted spread = $25.10 minus $24.90 = $0.20 per share.
- +2Relative quoted spread = $0.20 divided by $25.00 = 0.008, or 0.80%.
- +2Effective spread for the buy = 2 times ($25.06 minus $25.00) = $0.12 per share, or 0.48% of the midpoint.
- +1One-way midpoint shortfall = ($25.06 minus $25.00) times 800 = $48.
- +1The effective spread is below the quoted spread because the order improved on the displayed ask by $0.04 per share.
Key terms
- Tightness
- The cost of completing a small immediate trade.
- Depth
- The quantity available at or near current prices.
- Immediacy
- The speed with which a desired trade can be completed.
- Resilience
- The speed with which liquidity and prices recover after a shock.
- Quoted spread
- The best ask price minus the best bid price.
- Effective spread
- Twice the trade price's absolute distance from the midpoint.
Liquidity and Trading Costs FAQ
Can a market be deep but not tight?
Yes. A book may contain substantial quantity while the best bid and ask remain far apart. Liquidity dimensions need not move together, so depth cannot substitute for a direct tightness measure.
Why double the midpoint deviation in effective spread?
The convention expresses the observed one-way deviation as a round-trip spread comparable with the displayed bid-ask spread, which already spans both sides of the market midpoint.
Are commissions the full cost of trading?
No. Add implicit costs including spread, market impact, delay and missed-trade opportunity cost. These components can dominate the visible fee for a large or urgent order.
Why does trade size matter?
A small order may fill at the best quote, while a large order can consume several price levels and create greater price impact, worse average execution and slower recovery.
How do I reconcile several cost measures?
Choose one decision benchmark and one trade direction, then express every component in compatible dollar units. Brokerage and venue fees are explicit; spread, delay, impact and missed quantity are implicit. Their sum should explain the difference between the hypothetical portfolio at the benchmark and the actual portfolio after execution.
Exam move
Start every liquidity problem by naming the dimension being measured. Sketch the bid, midpoint and ask on one line, then mark the trade price before using any spread formula. Report dollars per share, percentages and total dollars separately. For comparison questions, explain why a measure changed: a tighter quote, deeper book, faster execution or quicker recovery tells a different story.
Keep a benchmark sheet with four rows: displayed quote, prevailing midpoint, actual fill and later price. From the first two derive quoted and relative spread; from midpoint and fill derive effective spread; from the later price evaluate realised impact. Label a buyer or seller before assigning direction. This avoids the frequent mistake of doubling a total dollar shortfall or comparing a percentage with cents per share.
Expand the cost ledger beyond commissions. Add exchange fees and brokerage as explicit costs, then spread, market impact, delay and missed quantity as implicit costs. Use a new numerical scenario to reconcile the components with the gap between a paper portfolio and actual outcome. For conceptual questions, test each liquidity claim against all four dimensions.
Heavy turnover does not prove a tight market; a narrow quote does not guarantee depth; a fast fill may come at severe impact; deep interest that never replenishes is not resilient. Conclude by identifying which trader, order size and horizon the chosen measure serves.
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