Market impact is the adverse change in a security's price resulting from the act of trading it. When you buy, the price tends to rise; when you sell, it tends to fall — partially because your trade signals private information (permanent impact) and partially because of temporary supply/demand imbalances that reverse after the trade (temporary impact).
Components
- Permanent impact — the lasting price change that persists after the trade, driven by the informational content of the order flow. Market makers update their view of fair value based on what informed traders appear to be doing.
- Temporary impact — the instantaneous price change from consuming liquidity that partially or fully reverses as liquidity providers replenish. Also called the mechanical or transient component.
Estimation
Market impact models (e.g., the Almgren-Chriss framework) express temporary impact as a power-law function of participation rate: impact ∝ (shares_traded / daily_volume)^η, where η is typically between 0.5 and 1.0. The parameters are estimated from institutional execution data.
Market impact is a key input to transaction cost analysis and determines whether a signal with positive gross IC is profitable net of trading costs at a given portfolio size.