Quoted depth and trading cost

Solution C, p.298, CFAI vol.5 Will the trading cost be higher or lower if the quoted depths are reduced? Why? - sticky

If depths are reduced I would say trading costs would be higher b/c without the large trades revenue would decrease for teh brokers and hence they would increase teh spread…just a thought but I dont think that’s what the CFAI is looking for. I’m going to have my cup of coffee and then I might come back to his :slight_smile:

Costs will be higher, because when depths are reduced for larger orders you will have to discover the price Willy when depths is reduced it doesnt mean volume decreases

Doesn’t depth have to do with order size? The larger the order the more the depth? So if large orders disappear volume decreases, no? Unless we have to assume that depth decreases but volume remains teh same??

CSK is correct - depth has to do with the maximum size of the order that the dealer is willing to fill at the quoted bid-ask spread. If a large order comes in, the dealer generally adjusts the bid-ask spread as a shield against potentially adverse information prompting that order. That is, trading costs go up.

13.00-13.25 200X300. 200 shares are bidding @ $13, 300 shares are asking @ $13.25. 1000 shares of buy order comes in, that is over the depth, you bet you will see the price go up===>higer trading cost.

thanks guys. - sticky

Less depth simply means less liquidity; therefore trading costs go up (especially for larger orders). Isn’t that the best way to think about it? Or is there an extra subtlety there?