Impact cost meaning in the stock market

The world of finance thrives on efficiency, where every transaction aims to achieve the desired outcome at the best possible price. However, there's an often-overlooked factor that can silently erode your returns: impact cost. This blog delves into the intricacies of impact cost, its implications for traders, and strategies to mitigate its effects.

What is the impact cost?

Imagine you spot a fantastic trading opportunity – a stock poised for a breakout. You place an order to buy a specific quantity of shares, expecting a swift execution at the prevailing market price. But reality can be different. Impact cost measures the hidden cost incurred due to the difference between the ideal execution price (based on the best bid and ask prices) and the actual average price you pay (or receive) when your order is filled.

Factoring in liquidity

The primary culprit behind impact cost is market liquidity. Liquidity refers to the ease with which an asset can be bought or sold at a fair price. In a highly liquid market, numerous buyers and sellers are actively trading, enabling orders to be filled quickly and close to the best bid and ask prices.

However, in markets with lower liquidity, there might be a limited number of buyers or sellers willing to transact at the prevailing bid or ask prices. This can lead to:

• Price Deviation: For buy orders, you might end up paying a higher average price than the best ask price if there aren't enough sellers willing to part with their shares at that level. Conversely, for sell orders, you might receive a lower average price than the best bid price if there aren't enough buyers willing to purchase at that price.
• Order Execution Time: In less liquid markets, it might take longer for your order to be filled entirely, potentially leading to missed opportunities or increased exposure to price fluctuations.

Impact cost: a silent drag on the returns

While impact cost might seem insignificant for small transactions, it can accumulate over time, especially for high-volume traders or those frequently entering and exiting positions in options trading. This can significantly erode potential profits or amplify losses.

How to reduce the impact cost?

Fortunately, there are strategies you can employ to minimise the impact of impact cost:

• Trade Liquid Assets: Prioritise stocks with high trading volumes and readily available shares. This increases the likelihood of your orders being filled at prices closer to the best bid and ask.
• Order Size Optimization: Break down large orders into smaller ones. This can help you achieve better average execution prices by gradually entering or exiting positions.
• Limit Orders: Utilise limit orders that specify the maximum price you're willing to pay for a buy order or the minimum price you're willing to accept for a sell order. This helps control the potential price deviation but might also lead to slower order execution.
• Patience is Key: Especially in less liquid markets, exercise patience when placing orders. Don't chase after the absolute best bid or ask price if it means potentially waiting a long time for your order to be filled.

Conclusion

Impact cost is an unavoidable reality in the world of trading. By understanding its causes and employing mitigation strategies, you can become a more informed and cost-conscious trader. Remember, managing impact cost is another step towards maximising your investment returns. So, stay informed, trade strategically, and keep those hidden costs in check.