Transaction Cost Modeling AI Prompt

Build a realistic transaction cost model for this trading strategy and assess its impact on performance.

Strategy: {{strategy}}
Asset class: {{asset_class}}
Typical position size vs ADV: {{position_vs_adv}}

1. Components of total transaction cost:

   a. Explicit costs:
   - Commission: broker fee per share or per dollar traded
   - SEC fee (US equities): $8 per $1M of sales
   - Exchange fees and rebates (maker/taker model)

   b. Implicit costs:
   - Bid-ask spread: cost of crossing the spread = 0.5 × (ask - bid) / midprice per trade
   - Market impact: additional cost of moving the market when executing large orders
   - Timing risk: price moves against you between decision and execution

   c. Short sale costs:
   - Short borrow rate: typically 0.5–2% annualized for easy-to-borrow stocks; can be >10% for hard-to-borrow
   - Locate fee: cost of finding shares to borrow before shorting

2. Bid-ask spread estimation:
   - Use quoted spread for liquid assets: (ask - bid) / midprice
   - Half-spread per one-way trip: 0.5 × quoted_spread
   - Historical spread data if available; otherwise estimate from Roll's model or Corwin-Schultz

3. Market impact model:
   Square-root impact model (Almgren-Chriss):
   Impact = η × σ × (Q / ADV)^0.5
   Where: η ≈ 0.1 (empirical constant), σ = daily vol, Q = trade size as fraction of ADV

   Linear impact model (simpler):
   Impact = κ × (Q / ADV)
   Where κ typically 0.005–0.02 depending on asset liquidity

   Apply at each trade and aggregate over the holding period.

4. Turnover-cost relationship:
   - Annualized one-way turnover rate from the strategy
   - Total annualized cost = turnover × (commission + half_spread + market_impact)
   - Drag on annual return: total_annualized_cost as % of AUM
   - Break-even Sharpe: what gross Sharpe is needed to achieve a net Sharpe of 0.5 after costs?

5. Sensitivity analysis:
   - Net performance at: 0× costs, 0.5× costs, 1× costs, 2× costs (stress test)
   - At what cost multiplier does net Sharpe fall below 0.5?
   - Which cost component has the largest impact: spread, market impact, or borrow?

6. Cost reduction strategies:
   - Reduce turnover: wider signal thresholds before rebalancing
   - Use limit orders instead of market orders to reduce spread cost (adds execution risk)
   - Optimal execution: stagger large trades over multiple days to reduce market impact
   - Netting: trade only the net change in position when multiple signals conflict

Return: cost model for each component, annualized total cost estimate, net performance table at different cost levels, and break-even analysis.