Market impact is the change in the price of a security caused by the execution of a large trade.
Understanding market impact
When investors place massive orders to buy or sell a security, the available liquidity at the current price level is often insufficient to fill the entire order. To execute the full trade, the buyer must accept higher prices from sellers further up the order book, or the seller must accept lower prices from buyers further down. This movement in the asset’s price directly resulting from the trade is market impact.
The degree of price movement depends on the liquidity of the specific security. Highly liquid assets, such as major currency pairs or large-cap stocks traded on global exchanges, absorb substantial order volumes with minimal price changes. Thinly traded assets like small-cap stocks or specific emerging market bonds experience significant price swings when a large order enters the market. Institutional investors measure this metric to understand the true cost of their trading activities.
Traders use execution strategies to minimize market impact. They split large orders into smaller trades executed over a longer time horizon using algorithms like volume-weighted average price or time-weighted average price. Alternatively, traders route orders to dark pools – private financial exchanges where order books are hidden from the public – to prevent other market participants from identifying the large trade and trading against it before the order is fully executed.
Example
Suppose you and your fellow Elephants manage an institutional investment fund and decide to buy two million shares of a moderately traded agricultural technology company. The current market price of the stock is $50 per share, but there are only 50,000 shares available at that exact price on the exchange. If the Elephants submit a single market order for the full two million shares, the broker buys the first 50,000 shares at $50.
The remaining 1,950,000 shares are bought at progressively higher prices as the order works its way up the order book, filling at $50.10, $50.50, and eventually up to $52. By the time the order is fully executed, the average price paid by the Elephants is $51.20. The $1.20 difference between the initial price and the final average execution price is the market impact of the large trade.