Market Impact

Market impact is the effect your own orders have on the price. When you buy, you consume sell orders and push the price up; when you sell, you push it down. For a small order in a liquid market, the effect is negligible. For a large order, or any order in a thin market, impact can be the largest trading cost of all, larger than commissions and the spread combined.

Why impact happens#

1. You use up liquidity. A buy order larger than the size at the best ask has to take higher priced offers. See The Order Book and Market Depth.
2. Others react. Market makers and fast traders detect persistent buying and raise their quotes, expecting more to come.
3. Information. Large trades can signal that someone knows something, shifting other traders' views of fair value.

Temporary and permanent impact#

How big is market impact?#

A widely cited rule of thumb, supported by many empirical studies, is that impact grows roughly with the square root of order size relative to volume:

Impact ≈ c × σ × √(Q ÷ V)

Here σ is the asset's daily volatility, Q is your order size, V is daily volume and c is a constant, often around 1, that varies by market. Doubling the order size raises impact by about 41%, not 100%. Real impact also depends on how fast you trade and on market conditions.

Who needs to worry about impact#

• Funds and institutions trading large positions.
• Traders of small caps, small tokens, far dated options and thin futures, where even modest orders move prices.
• Strategies that trade the same direction as everyone else, such as momentum at the open.

For most retail orders in large stocks or major futures, impact is close to zero and the spread dominates.

Reducing market impact#

1. Trade smaller. Keep orders to a small fraction of typical volume and of the size shown at the best price.
2. Spread orders over time. Execution algorithms such as VWAP, TWAP and participation algorithms slice large orders. See VWAP, TWAP and POV Execution.
3. Use limit and passive orders to supply liquidity instead of taking it.
4. Trade in liquid periods and venues; auctions at the open and close concentrate liquidity. See Opening and Closing Auctions.
5. Hide size with iceberg or midpoint orders. See Hidden and Iceberg Orders.
6. Balance speed against impact. Trading slowly reduces impact but risks the price moving away for other reasons. Optimal execution models formalise this trade off. See Optimal Execution and the Almgren-Chriss Model.

Impact and strategy capacity#

Market impact limits how much money a strategy can manage. A strategy that works with $100,000 may fail with $100 million because its own trades move prices too much. This is called capacity. See Alpha Capacity and Crowding.

Frequently asked questions#

What is market impact in trading?#

The change in price caused by your own buying or selling, which raises the cost of completing large orders.

How do you reduce market impact?#

Trade smaller pieces over time, use passive orders, trade during liquid periods and use execution algorithms for large orders.

Is market impact the same as slippage?#

Impact is one cause of slippage. Slippage also includes price moves unrelated to your order, such as news or delay.

Sources#

• Wikipedia, Market impact