Compute effective spreads and VWAP-based estimates of transaction cost, and explain what they show
The idea
The effective spread compares the trade price with the prevailing midpoint: effective spread = 2 × |trade price − midpoint|. With a bid of 20.00, ask 20.10 and a purchase at 20.08, the midpoint is 20.05 and the effective spread is 0.06, below the 0.10 quoted spread, indicating price improvement. The VWAP measure compares the average execution price with the market's volume-weighted average price. For a purchase averaging 25.20 against a VWAP of 25.12, the cost is 0.08 ÷ 25.12 ≈ 31.8 bps; for sales, the sign reverses. VWAP can be gamed by spreading trades over the day, and it ignores unfilled orders. Traps include forgetting the factor of 2 and the side of the trade.
Formulas
Effective spread
effective spread = 2 × |trade price − midpoint|
- trade price
- the price actually paid or received
- midpoint
- the midpoint of the bid and ask when the order was placed
Unlike the quoted spread it captures price improvement and slippage. Half of it is the cost of one side of a round trip.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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