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The impact of impact cost

When making transactions with huge quantities, traders also have to think about liquidity and the associated impact cost

As most stock traders know, brokerage and trading fees are an omnipresent cost when trading securities. This is the fee everyone has to pay to transact in the market. Sometimes this goes to the market maker, other times it goes to the brokerage app you use to buy and sell stocks

In this article, we’re going to talk about impact cost – which is another everpresent cost that traders have to keep in mind when buying and selling illiquid securities in bulk.

Understanding impact cost

Impact cost, in essence, refers to the hidden cost associated with executing a trade. It reflects the difference between the ideal price you expect to pay or receive for an asset and the actual price achieved due to the impact your trade has on the market.

Imagine wanting to buy 100 shares of a stock at the current ask price of ₹100. However, due to the size of your order and the limited availability of sellers at that price, you might end up paying a slightly higher price, say ₹104. The ₹4 difference represents your impact cost.

There are some components that directly affect the impact cost you have to bear when executing such trades:

  • Size of your transaction / order – Larger orders are more likely to have a higher impact cost. When you buy or sell a significant quantity of an asset, it can move the market price, pushing the price you pay or receive away from the ideal price.
  • Liquidity of the associated market – Larger stock markets and stock of bigger companies tend to have more liquidity than obscure markets and penny shares. The impact cost tends to be lower in liquid markets with a large number of buyers and sellers. Since there are many buyers and sellers on the other side, it is difficult for your trade to change the price. Conversely, in less liquid markets with fewer participants, your order can have a more significant impact on the price, leading to a higher impact cost.
  • Order type – If you place a large market order at once, you will more likely have a higher impact cost. Limit orders, which specify a price limit, usually have a lower impact cost to the trader.

Why is understanding impact cost important?

Impact cost subtly eats away at your potential profits or magnifies losses on both buy and sell sides.

When selling an asset in bulk, the supply becomes more than the demand in an illiquid market, which pushes prices down. Hence, as your order gets filled slowly, the market is prepared to give you a lower and lower price for your stock.

On the other hand, when buying in bulk, demand exceeds current supply, which makes your buying costs inch higher and higher as the market demands more money to fill your trade.

In both circumstances, either by buying higher or selling lower, you’re losing out on profits.

Minimising impact cost

If you find yourself in such a situation where you have to buy or sell a large quantity of stocks at one time, here are a few things you can do to minimise your impact cost:

  • Embrace smaller order sizes – Breaking down large orders into smaller chunks can help reduce the overall impact on the market price and potentially lower your impact cost.
  • Focus on assets and markets that have more liquidity – Focus on trading assets with high liquidity, where there are ample buyers and sellers. This will reduce your chances of moving the price against you.
  • Limit orders are your friend – By placing limit orders that specify a desired price limit, you can avoid the immediate execution priority of market orders and potentially achieve a better price. This is both for buying and selling.
  • Consider using algos – Advanced traders can utilise algorithmic trading strategies that automatically break down large orders into smaller chunks and execute them over time, minimising market impact.

Frequently Asked Questions

What is the difference between an impact cost and a spread?

The key difference between impact cost and bid-ask spread lies in their origin. Bid-ask spread is a visible fee charged by the market maker or exchange for facilitating the trade. It’s the difference between the bid (highest price a buyer is willing to pay) and ask (lowest price a seller is willing to accept) for an asset. Impact cost, on the other hand, is a hidden cost arising from the influence your order has on the market price.

How do trading algorithms work?

Trading algorithms follow programmed rules to analyse markets, identify trade signals, and execute orders automatically.  Retail traders can use these algos, but they require coding knowledge or pre-built platforms.

Is slippage the same as impact cost?

They are related, but they’re not the same. Impact cost is like the ripple effect caused by your large trade moving the market price slightly. On the other hand, slippage is the gap between your aim (quoted price) and the actual bullseye (filled order price).

What are some illiquid tradable securities?

Some of them are micro-cap stocks, penny stocks, restricted stock units (RSUs), complex bonds, exotic options, or foreign bonds issued by smaller or inaccessible countries.

Which is the most liquid market in the world?

The most liquid market in the world is the foreign exchange market (forex market). The forex market operates 24/5, across all time zones, with trading happening continuously around the world. Estimates suggest daily forex transactions can reach $5 trillion or more, exceeding the combined daily trading volume of all stock exchanges globally.

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