Where have you come across the word “market impact”: It is the common word for large investors whenever they decide to open a trade by moving an amount. An example of this can be a trader noticing another trader for placing an order limit to sell a large volume of assets and choosing to short sell their stocks as a result.
What is Market Impact?
In the monetary market, market impact refers to the effect caused by a market participant on buying or selling an asset or security. It is the extent to which selling or purchasing moves the rates against the seller or buyer, i.e., downward while selling an asset and upward while buying an asset.
The term market impact is nearly related to market liquidity. In many cases, both these terms work hand in hand. For large investors, the market impact and financial institution are essential and vital terms. They consider them before carrying out any investment between or within the commercial market.
If the value of money that is being moved is higher than the relative turnover; then impact would be several percentages. In this case, the impact should be assessed along with the other transaction cost (buying and selling cost).
The market impact is not only because of price movements that tempt other traders to sell and buy assets but also because the professional investor seeks knowledge from large traders and trade the same active group.
Some financial instruments have meagre transaction costs. The cost is so low that they gain from small price movements, that the majority of traders do not consider relevant. The monetary institution that is trying to manage its market impact requires to limit the speed of its activity (activity should be below one-third of daily turnover) to avoid disrupting prices.
Market Impact Cost
Market impact cost is the degree of market liquidity which indicates the amount faced by an investor of a security or index. It is a type of transaction costs. It also reflects the additional cost that a trader has to pay in addition to the initial price due to market slippage.
Measuring Market Impact
Various methods can measure the market impact, but the most simple and frequently used way is Kyle’s Lambda.
The word Kyle’s lambda is derived from a famous paper by Pete Kyle (deals with topics on market microstructure).
The rate of change of trade price with respect to volume gives us the impact rate (considering a short period). The volume includes the turnover or the number of stocks traded. On calculating the impact, it is seen that a highly liquid share is the one that undergoes a small price change for the provided level of the trading volume.
Challenges For Microcap Traders
Characteristics of nanocap and microcap are that they have a comparatively low stock price, less daily volume and relatively limited float. These shares are sensitive and extremely volatile to large cost swings because they have limited float and are not traded frequently.
Microcap investors usually trade in and out positions with a vast lot of stocks to make fast money on uncertain events. And here lies a problem which many microcaps traders face. There is a shortage of stocks resulting because of large block orders, limited float availability and a thin volume of trade.