What Is a Frictionless Market?
A frictionless market is a theoretical trading environment where all costs and restraints associated with transactions are non-existent.
How a Frictionless Market Works
Frictionless markets can be used in theory to support investment research or trading concepts. In investing many performance returns will assume frictionless market costs. It is important for investors to view both friction analysis and frictionless analysis for a realistic understanding of a security’s return. Pricing models such as Black-Scholes and other methodologies will also make frictionless market assumptions which are important to consider since actual costs will be associated with real world applications.
Trading and Friction Analysis
The emergence of new trading platforms for investors through financial technology innovation is broadening the scope of market activity and helping to move toward nearly frictionless markets. Platforms such as Robinhood provide one example with their no fee trades which nearly eliminates friction trading costs. However, they and other retail brokers sell their customers' order-flow to market makers. As competition increases, trading costs are also continuously decreasing which helps to reduce friction costs.
Choosing brokerage platforms that provide performance returns inclusive of trading fees or requesting these types of reports from a financial advisor is one base for friction analysis. Charles Schwab is one discount brokerage platform that provides performance returns inclusive of trading fees which can help to provide greater performance transparency.
In addition to trading costs there are also some other friction costs that an investor must consider. In general, friction analysis can help investors to understand these costs by integrating both the direct and indirect costs of investing.
Taxes are one important variable that investors must consider in friction cost analysis. Taxes will vary based on short-term or long-term capital gains but in either situation they still must be paid if an investor takes any profits from their investments.
In some situations investors may also assign an indirect cost to frictions associated with market trading. For example, researching and identifying platforms where investments are listed and deciphering their required minimum investments may be one area where an investor would assign a higher cost to trading than the standard commission requires.
Price Models and Investment Analysis
In analyzing any type of investment it is important for an investor to outline their indirect and direct costs in order to have a full understanding of their return on investment. In academic research this may not always be plausible since it complicates the theories for which investing models are based.
One such example is the Black-Scholes Pricing Model, which is a model for identifying the market price of an option on an underlying security. Important variables for consideration in this pricing model include the price of the underlying security, the volatility of the security and the time to expiration. These variables provide a market price for an option but they do not take into consideration the cost of trading commissions which decreases the overall gains available in the investment market.