Market Impact
Market impact (MI), sometimes also referred to as slippage, is a very important component of total trading costs. It is an implicit trading cost that most investors are not very much aware of.
On this page, we explain the definition, discuss important MI models, and discuss an example of how we can observe the likely MI from the order book.
Market Impact definition
When executing a transaction, most investors only consider explicit transaction costs. These are the taxes, brokerage commissions, and other fees that have to paid. This is, however, only part of the total transaction cost. Moreover, when executing large trades, implicit transaction costs can quickly become the dominant part of total transaction costs.
Market impact is the most important part of implicit transaction costs. The other important part of implicit transaction costs is the implementation shortfall.
The best way to think of MI is to consider the synonymous term that is used, i.e. “slippage”. MI is basically the result of the price that ‘slips’ down (or up) when you sell (or buy) a security. This is because you can typically not execute the entire order at the best bid (or ask). Instead, the first part of your order is executed at the best price, of the amount that is on offer. Then, you move down the order book. We discuss an example of how this happens below.
Market Impact model
There are several market impact models. First, there are the MI models that are sold by data vendors and investment banks. The most commonly used market impact models currently available for investors are Bloomberg’s market impact model as well as Goldman Sachs’ shortfall model.
It is, however, also possible to calibrate your own model using as a basis MI models proposed by economists. Arguably the most widely used market impact model in this context is the market impact model proposed by Almgren & Chriss (2003). When asset managers have the necessary transaction data, they will typically fit their transaction data to the Almgren and Chriss market impact model to forecast the likely market impact of new similar trades.
Market impact analysis
Market impact analysis (MIA) is very important. A rough proxy to limit market impact is often to used an average daily volume (ADV) constraint. Dealing desks well often talk about a trade as being “high-touch” or “low-touch”. A low-touch trade is a trade that is not expected to move markets too much, i.e. the trade is only a small percentage of ADV. A high-touch trade, however, can be expected to have a big impact on the price. In that case, dealing desks may decide to split up the trade.
It is very important to perform MIA. Explicit transaction costs are one thing, but if investors’ trade have too much impact on prices, the alpha they wish to capture will decay very quickly.
Market impact cost example
Finally, let’s discuss a short example of how impact can be estimated by looking at the order book. Suppose we want to execute a buy trade of 500 shares. The order book looks as follows:
100 $15.00
200 $15.05
400 $15.10
This means that we will be able to buy a 100 shares at $15. The other part of the trade, however, will be at a higher price. In particular, we will be able to buy another 200 shares at 15.05 and 200 shares at 15.10. As a consequence, rather than paying $15 for the 500 shares, we paid 15.06 in total. As you can see, the price ‘slipped’.
Summary
We discussed MI, an implicit transaction cost that is typically larger than explicit transaction costs. It is often ignored by investors. For retail investors, this is typically not a problem as most of their trade will be executed at the best ask or best bid. For institutional traders, however, slippage can be significant.