CHAPTER 2

Potential Profit and Transaction Costs

Pardo's algorithm for evaluating potential profit includes even the tiniest price changes and uses them to his advantage. These small price changes can be profitable because it assumes that transaction costs are zero. In real life, transaction costs can turn winning trades into losing ones. A price change should be large enough to compensate for all costs and still net a profit. Transaction costs are an important factor that influence trading decisions and change the number of profitable trades, their distribution in time, and the size of the profit. An algorithm for evaluating potential profit when costs are taken into account becomes more complicated. In this chapter, I analyze the properties of the potential profit strategy we began in Chapter 1 and introduce some notions necessary for building an algorithm to generate that strategy. The algorithm itself will be constructed in the next chapter.