Quick definition Market impact is the price change caused by your trade, not by changes in news or information. A large buy order pushes the price up. A large sell order pushes it down. This is the cost of consuming liquidity. What it is Market impact has two components: temporary and permanent. Temporary impact is the cost of crossing the spread and moving through available liquidity. The next trader in the opposite direction experiences a tighter spread, so temporary impact is temporary. Permanent impact is the price movement that persists after your trade, reflecting that inventory has shifted and the market has absorbed your order. Why it matters Market impact is the largest cost for institutional traders executing large orders. A pension fund buying 1 million shares in a thinly traded stock can move the price 1 percent or more. This cost cannot be avoided when trading large size, but it can be minimized by spreading the trade over time and adapting to market conditions. Market Impact versus Slippage Slippage is the difference between your expected execution price and your actual fill price. Market impact is one cause of slippage, but so is market movement between order submission and execution. Practical example You need to buy 1 million shares of a small-cap stock with 2 million shares average daily volume. The current price is 25.00 dollars. A single market order for 1 million shares consumes most of the available liquidity, moving the price from 25.00 to 27.50 dollars. Your average fill is 26.50 dollars, a 1.50 dollar (6 percent) permanent impact. Instead, you use a VWAP algorithm that buys 200,000 shares per day for 5 days, staying proportional to expected volume. The total market impact cost is 0.15 dollars, or 3 basis points, a 98 percent improvement. Impact factors Market impact is higher in thinly traded securities, during volatile periods, and for larger order sizes. Venues with deep liquidity (NASDAQ, NYSE) have lower impact than smaller exchanges. The relationship between order size and impact is non-linear; doubling your order size more than doubles the impact. See also - Slippage - Implementation Shortfall - VWAP (Volume-Weighted Average Price) - Execution Algorithm - Liquidity
