Episode 8: Implicit Trading Costs Matter Part 1 - Cost Dynamics
Implicit trading costs make up the greatest share of execution costs for investors. These costs depend on several factors such as trade timing and tactics, including the choice of liquidity pool and trading venue. For the most liquid French stocks in YTD2026, the lit book mid price moved by an average of 1.47 bps within one millisecond of a trade, illustrating the immediate contribution to trading costs of price sensitivity to trading activity.
After five minutes, that change was up to 16.39 bps. On a €50mn basket, this translates to a cumulative unrealised cost or saving of up to €81,950 to the portfolio, depending on the basket’s positioning versus price trend.
As discussed in Episode 3 of Liquidity Matters, relying solely on the 'at-touch spread' gives an incomplete picture of trading costs. It captures explicit costs, such as venue and settlement fees, but only a small fraction of implicit costs (see Notes section for an explanation of implicit cost). For the most liquid French stocks, half the at-touch spread is around 2 basis points, which represents only 12% of the cost measured from the mid price at execution to the mid price five minutes later.
To discover the full cost of a trade, a broader measurement timescale is needed. By using pre and post trade ‘mark-outs’, we can accurately measure the key components of implicit trading cost contributors such as market impact and adverse selection throughout the life of a trade. Mark-outs are the differences in the market mid price between the time of each print and a series of time points before and after - it’s an ‘MRI scan’ of the parent trade.
Figure 1: The FR40 chart displays absolute price changes to the PBBO mid price at various time offsets (‘mark outs’) before and after execution, in milliseconds. Each line represents the change in the PBBO prior to and following a trade reported by the given type of liquidity pool. For example, the purple line shows the reaction of the PBBO to dark pool prints. The series converges at execution offset=0 and diverges post-trade.
A price reverting market will reduce the mark-out values as price returns towards its original level following trading activity, whereas a trending market will increase them during a change to fair value. These measurements form a key role in post trade analysis and a major factor in explaining benchmark performance and the assessment of trade timing and tactics such as liquidity pool and limit price selection.
Figure 1 shows the immediate change at the 1 ms mark-out of 1.47 bps in the Lit Order book after execution. This reduces to 0.15 for a dark pool, appearing more attractive at the one-millisecond mark. However, over five minutes, the cumulative cost reverses: dark pools reach 16.39 bps versus 14.39 bps for lit pools. The evolution matters as the initial cost advantage of the dark pools appears to erode as price momentum unfolds.
Note that these numbers are absolute. A buyer in a moving market ‘wins’ a discount for trading early in a rising market, assuming the new price holds. A seller has paid a premium. This illustration is highly generalised but forensic analysis of an investor's own trades (with side included) can use mark-outs as ‘micro benchmarks’ to test whether the trading tactics are more or less efficient than the market average throughout the life of a trade, and measure aggregate impact.
Not every trade results in a change in price, which explains why the immediate mark-out is less than half a spread. A well balanced order book with a thick queue is less volatile than an unbalanced order book with a thin queue. The latter will result in faster, larger movements in price reflecting volatility and liquidity imbalances. Therefore mark-outs provide deep insight to the prevailing liquidity quality during a trade. While not shown here, mark outs to the closing price on T0 and for several days before and after a trade help explain how much trading cost is associated with general and exogenous movements in a stock and its relationship to comparables in an index.
Liquidity Pool Differences and Venue Selection
In the next episode of Liquidity Matters we will dive into the differences in behaviour between types of Liquidity Pool. For illustration, Figure 1 demonstrates how using different types of liquidity pool can impact and reduce short term implicit trading costs. There is a strong convergence of price impact after five minutes suggesting that venue selection has only a short term effect.
Most notably, the graph reinforces how trading in alternative venues can reduce short term implicit trading costs at the 1 ms mark-out - by 1.3 bps for dark pools and 1.43 bps for periodic auctions). Unlike dark pools, periodic auctions retain a small discount to the Lit Order Book mark-out as price evolves. This reflects the growing popularity of periodic auctions, as highlighted in Episode 7.
Conclusion
The mark-out framework built around observing mid price movements before and after a trade provides the precise measurement of execution costs that spread-based metrics alone cannot capture.
Pre-trade mark-outs assess whether an algorithm's directional predictions and trade timing decisions were sound.The scale of this is significant. A strategy that executes at mid in French large caps could pay or retain up to 16.39 bps on average in the five minutes per print.
A strategy that is well-tuned to market microstructure, uses alternative venues, deploys agile order placement logic, and accurately predicts short-term price direction, will maximise this benefit or minimise the cost.
The mark-out dataset is one of the most powerful tools available for determining whether your execution is capturing fair value or surrendering it to the market.
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Notes on types of Implicit Costs.
Effective spread cost: This is half the prevailing spread at the time of a trade, and is the premium paid to a liquidity provider for immediacy. It varies according to volatility and market concentration/competition. Because the spread embeds explicit trading and settlement fees, implicit trading cost can be detected by looking at the general trend in the effective spread. This is shown in Liquidity Matters Episode 3 - “Why Spreads Matter”.
Market Impact: Using the analogy of the buyer, if the buyer is large in size, and is alone in the market, price is likely to fall back (revert) to fair value when the trade is completed. Such a trade has temporary market impact and the initial premium will be eroded, potentially to become a cost. This is valuable liquidity for counterparties. If the buyer is part of a group of traders who are large in size this implies a momentum trade where a new fair value is set and the buyers together have induced permanent market impact.
Adverse Selection: This type of cost affects passive trading. Entering orders onto the near touch may attract an immediate benefit, but if the price ‘moves through’ the near touch then that benefit becomes a cost. This is a risk for passive traders who hold their position when market momentum is against them, and there is no fair price reversion but a way to capture spread when price is stable. This is especially true when high order routing latency means market orders join the order book at the back of the queue or when orders are placed to jump the queue by making a new best price which is then unsustained. Measures of queue position complement mark-outs analysis to help optimise trading tactics accordingly.