Cost & Slippage Model (stress bps)
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Definition
The assumptions that convert gross backtest returns into net: commissions, exchange/regulatory fees, bid-ask spread, borrow, and market impact. 'Stress +Nbps' re-runs the backtest with N extra basis points of round-trip cost to test how much edge survives.
How to read it
Costs are where paper edges go to die. A strategy's net performance is roughly gross minus (turnover x cost-per-trade), so high-turnover strategies are exquisitely sensitive to the cost assumption. The stress test - add 5 or 10 bps and see what remains - is a fragility probe: if net Sharpe or net return collapses under a modest cost bump, the strategy is trading a spread it cannot actually capture at size. Always model impact as increasing with order size relative to average daily volume, not as a flat fee.
How practitioners use it
Used as context among multiple indicators — never as a standalone signal to act.
Less common professional uses
Market impact is typically modeled as a concave (square-root) function of participation rate: impact ~ spread + k*sigma*sqrt(Q/ADV), so doubling order size does NOT double impact but capacity still degrades Sharpe as AUM grows - always report a capacity curve, not a single net Sharpe. Backtests that fill at the mid or at the signal-bar close embed look-ahead and free liquidity; realistic fills should cross the spread and, for stop/urgent orders, assume adverse selection (you trade exactly when the market moves against you). The gross-to-net Sharpe decay is the most reliable over-fit tell after Deflated Sharpe: a strategy whose entire alpha is inside 3 bps of assumed spread is fitting the cost model, not the market. Borrow cost and hard-to-borrow rates make short-side backtests optimistic; short alpha must clear the specials rate, which is regime- and name-dependent.
Sources & provenance
Almgren & Chriss (2000), 'Optimal Execution of Portfolio Transactions'; Kyle (1985) market impact; Grinold & Kahn, 'Active Portfolio Management'
This page is educational content published by Pachira Aquatica Global LLC. It is not investment advice and not a recommendation.