What is Impact Cost in Trading?

Understanding impact cost helps traders evaluate how market liquidity affects their trades and the real cost of entering or exiting positions.

Impact cost represents the hidden cost of trading caused by the market’s reaction to an order. It occurs because large or urgent orders can move the price away from the ideal quote.

Key points to remember:

• Impact cost is not a brokerage or exchange fee.
  

• It measures the difference between the expected price and the executed price.
  

• It is closely related to liquidity, with illiquid stocks typically showing higher impact costs.

The impact cost formula can be expressed as:

• Impact Cost (%) = [(Actual Execution Price − Ideal Price) ÷ Ideal Price] × 100

Where:

• Actual Execution Price = Price at which the order is completed
  

• Ideal Price = Mid-point of the best bid and ask price

Impact cost is a vital measure for traders, especially in intraday and large-volume trading. Here’s why it matters:

• Evaluates Market Liquidity: Higher impact cost indicates lower liquidity.
  

• Helps Choose the Right Stocks: Traders can avoid illiquid stocks where costs are higher.
  

• Assists in Cost Analysis: It reveals the real cost of executing trades beyond visible charges.
  

• Optimises Trading Strategies: Understanding impact cost helps traders split orders or time trades better.

Several market conditions and trading behaviors influence impact cost:

• Liquidity of the Stock: Highly liquid stocks have lower impact costs.
  

• Order Size: Larger orders can move prices more significantly.
  

• Market Volatility: Higher volatility can lead to wider spreads and increased costs.
  

• Order Type and Timing: Market orders during low volumes often result in higher impact cost.

Consider a stock with the following market data:

• Best Bid Price: ₹100
  

• Best Ask Price: ₹102
  

Ideal Price = (100 + 102) ÷ 2 = ₹101

If a trader places a market buy order for a large quantity and the average execution price is ₹101.50:

Impact Cost = [(101.50 − 101) ÷ 101] × 100 = 0.495%

This means the trade cost the trader an additional 0.495% due to market impact.

Traders can minimise impact cost with careful strategies:

• Trade in Liquid Stocks: Stick to stocks with high trading volumes.
  

• Use Limit Orders: Avoid market orders for large trades.
  

• Break Large Orders: Split trades into smaller quantities.
  

• Monitor Market Timing: Execute trades during peak market hours for better liquidity.

Impact cost is an essential metric for evaluating the hidden costs of trading in the stock market. By understanding how order size, liquidity, and market conditions affect execution prices, traders can make more informed decisions and optimise their strategies to reduce trading costs.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.