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In 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 many cases "liquidity" and "market impact" are synonymous.
Especially for large investors, e.g. financial institutions, market impact is a key consideration that needs to be considered 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.
Measuring market impact
Several statistical measures exist. The most common and simplest is Kyle's Lambda, defined as the slope from regressing absolute returns to volume over some time window (often as short as 15 minutes). For very short periods, this reduces to simply
Volume is typically measured as turn-over or the value of shares traded, not the number. Under this measure, a highly liquid stock is one that experiences a small price change for a given level of trading volume.
Measuring market impact is, however, very difficult task and errors in estimating the market impact can highly impact the optimal strategy of trading.
Unique challenges for microcap traders
Microcap and nanocap stocks are characterized by very low share prices and a relatively limited float and thin daily volume. Since these types of stocks have such limited float and are so thinly-traded, these stocks are extremely volatile and very 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.
Suppose an institutional investor places a limit order to sell 1,000,000 shares of stock XYZ at $10.00 per share. Now a professional investor may see this, and place an order to short sell 1,000,000 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.
- Kyle, Albert (November 1985). "continuous Auctions and Insider Trading". Econometrica 56 (3): 129–176.
- Moazeni, Somayeh; Thomas Coleman, Yuying Li (2010). "Optimal Portfolio Execution Strategies and Sensitivity to Price Impact Parameters". SIAM Journal on Optimization 20 (3): 1620–1654.
- Market impact and trading profile of large trading orders in stock markets
- Robert Almgren; Chee Thum; Emmanuel Hauptmann; Hong Li (May 10, 2005). "Direct Estimation of Equity Market Impact" (pdf). Retrieved September 27, 2012.