Definition
Transaction costs are everything it costs to enter and exit positions beyond the price move itself. They include explicit charges such as commissions, exchange fees and taxes, and implicit costs such as the bid-ask spread, slippage and market impact.
How it works
Explicit costs appear on the trade confirmation; implicit costs show up as the difference between the price you expected and the price you obtained. Spread and slippage generally widen in illiquid or fast-moving markets and for larger orders, and leveraged or short positions can add financing or borrowing charges.
Costs are paid on every trade, so their drag grows with turnover: approximately round trips per year × cost per round trip. A strategy whose average gain per trade is smaller than its cost per trade has no edge after costs, however good the gross figures look.
Formula / convention
Net P&L = Gross P&L − (commissions + fees + taxes + spread cost + slippage + market impact + financing); Annual cost drag ≈ round trips per year × cost per round trip
Illustrative example
Illustrative: a fictional strategy makes 120 round trips a year with an average gross gain of 0.50% per round trip. If commissions, fees, spread and slippage cost 0.40% per round trip, the net gain is 0.10% per round trip, so a cost drag of 120 × 0.40% = 48% shrinks a gross 120 × 0.50% = 60% to 120 × 0.10% = 12% (simple sums, ignoring compounding).
What to watch for
A backtest that ignores or underestimates costs overstates results, and the error is largest for frequent trading, small or thinly traded instruments and large orders. Stress-test by doubling the assumed costs to see whether the result survives; cost rates and tax rules also change over time and differ by market.