financial markets A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial markets ...

, market impact is the effect that a market participant has when it buys or sells an asset. It is the extent to which the buying or selling moves the price against the buyer or seller, i.e., upward when buying and downward when selling. It is closely related to

market liquidity In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity involves the trade-off between the ...

; in many cases "liquidity" and "market impact" are synonymous. Especially for large investors, e.g.,

financial institution Financial institutions, sometimes called banking institutions, are business entities that provide services as intermediaries for different types of financial monetary transactions. Broadly speaking, there are three major types of financial insti ...

s, market impact is a key consideration before any decision to move money within or between financial markets. If the amount of money being moved is large (relative to the turnover of the asset(s) in question), then the market impact can be several percentage points and needs to be assessed alongside other transaction costs (costs of buying and selling). Market impact can arise because the price needs to move to tempt other investors to buy or sell assets (as counterparties), but also because professional investors may position themselves to profit from knowledge that a large investor (or group of investors) is active one way or the other. Some financial intermediaries have such low transaction costs that they can profit from price movements that are too small to be of relevance to the majority of investors. The financial institution that is seeking to manage its market impact needs to limit the pace of its activity (e.g., keeping its activity below one-third of daily turnover) so as to avoid disrupting the price.

Market impact cost

Market impact cost is a measure of

market Market is a term used to describe concepts such as: *Market (economics), system in which parties engage in transactions according to supply and demand *Market economy *Marketplace, a physical marketplace or public market Geography *Märket, an ...

liquidity that reflects the cost faced by a trader of an

index Index (or its plural form indices) may refer to: Arts, entertainment, and media Fictional entities * Index (''A Certain Magical Index''), a character in the light novel series ''A Certain Magical Index'' * The Index, an item on a Halo megastru ...

security Security is protection from, or resilience against, potential harm (or other unwanted coercive change) caused by others, by restraining the freedom of others to act. Beneficiaries (technically referents) of security may be of persons and social ...

. The market impact cost is measured in the chosen numeraire of the market, and is how much additionally a trader must pay over the initial price due to market slippage, i.e. the cost incurred because the transaction itself changed the price of the asset. Market impact costs are a type of

transaction cost In economics and related disciplines, a transaction cost is a cost in making any economic trade when participating in a market. Oliver E. Williamson defines transaction costs as the costs of running an economic system of companies, and unlike produ ...

Measuring market impact

Several statistical measures exist. One of the most common is Kyle's Lambda, estimated as the coefficient

\lambda

from regressing price changes

P_t

on trade size

y_t

over some time window. :

\mathrm_t = \mu + \lambda\mathrm_t

For very short periods, this reduces to simply :

\lambda = \frac

Volume is typically measured as turnover or the volume of shares traded. Under this measure, a highly liquid stock is one that experiences a small price change for a given level of trading volume. Kyle's lambda is named from Pete Kyle's famous paper on

market microstructure Market microstructure is a branch of finance concerned with the details of how exchange occurs in markets. While the theory of market microstructure applies to the exchange of real or financial assets, more evidence is available on the microstructu ...

Unique challenges for microcap traders

Microcap In business and investing, term microcap stock (also micro-cap) refers to the stock of public companies in the United States which have a market capitalization of roughly $50 million to $300 million. The shares of companies with a market capitali ...

(and nanocap) stocks are characterized by a market cap under $300mn ($50mn) relatively limited

public float In the context of stock markets, the public float or free float represents the portion of shares of a corporation that are in the hands of public investors as opposed to locked-in shares held by promoters, company officers, controlling-interest inv ...

and small daily volume. As a result, these stocks are extremely volatile and susceptible to large price swings. Microcap and nanocap traders often trade in and out of positions with huge blocks of shares to make quick money on speculative events. And therein lies a problem that many microcap and nanocap traders face—with so little float available, thin volume and large block orders, there is a shortage of shares. In many instances orders only get partially filled.

Example

Suppose an institutional investor places a limit order to sell 1 million shares of stock XYZ at $10.00 per share. A professional investor may see this limit order being placed, and place an order of their own to short sell 1 million shares of XYZ at $9.99 per share. * Stock XYZ rises in price to $9.99 and keeps going up past $10.00. The professional investor sells at $9.99 and covers his short position by buying from the institutional investor. His loss is limited to $0.01 per share. * Stock XYZ rises in price to $9.99 and then comes back down. The professional investor sells at $9.99 and covers his short position when the stock declines. The professional investor can gain $.10 or more per share with very little risk. The institutional investor is unhappy, because he saw the market price rise to $9.99 and come back down, without his order getting filled. Effectively, the institutional investor's large order has given an option to the professional investor. Institutional investors don't like this, because either the stock price rises to $9.99 and comes back down, without them having the opportunity to sell, or the stock price rises to $10.00 and keeps going up, meaning the institutional investor could have sold at a higher price.

References

External links