Market Impact And Small Cap Stocks

What Is Market Impact?

Market Impact refers to the price of a stock being affected by orders for that stock. The larger the orders the larger the Market Impact. The thinner the volume of a stock the larger the Market Impact as well. For example if we have a stock that is trading at $5 and a large institutional investor decides to buy 100,000 shares it’s pretty rare for all 100,000 shares to cross at $5 with a small cap stock that only has trading volume of 10,000 shares per day. It’s more likely that the first shares cross at $5 and the last shares of the 100,000 cross at maybe $6. That increase from $5 to $6 is a 20% market impact.

If the investor has a sell target of $7 then they were expecting a 40% return from buying at $5 and selling at $7. But the Market Impact also works on the sale of those 100,000 shares. So if the stock reaches $7 and the investor decides to unload all 100,000 shares again the first few shares may cross at $7 and the last few shares may cross at $6. It’s conceivable that the Adjusted Cost Base was $5.50 and the Average Sale Price was $6.50. This represents something closer to an 18% return versus the desired 40%.

Market Impact Is Prevalent For Small Caps

This is a crude example and an institutional investor would not blindly trade like this, they would be well aware of Market Impact. However,  Small Cap Index funds would be required to make trades in order to minimize tracking error and therefore ignores the costs of Market Impact. This may be a major reason that Small Cap fund managers have a slightly easier time beating their benchmark indices (although the results on average are still not anything to write home about) – they can spread out their purchases over time so as to not impact the stock’s price so quickly that they eat much of their potential gains through Market Impact costs.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 5 comments
  • Michael James

    Nice explanation of market impact. This provides background for Warren Buffett’s claim that his universe of potential investments shrinks as his pile of money increases.

  • Preet

    @Michael James – Thanks and you make a good point. Further, what is even more interesting is that even with this hurdle he has managed to deliver extraordinary results.

  • Finance

    It seems that the impact of transactions on stock price (market impact) is a function of the size of the order. Any theory that suggests why this is so?

  • Preet

    @Finance: There are only so many buyers/sellers, so if you place a large order you can chew through the bids/asks quite quickly. Lower liquidity stocks with thin market depth will be especially vulnerable.

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  • […] This is one area where CNDA might have an advantage. It looks like CNDA has a higher market capitalization minimum for inclusion – meaning that companies have to be of a certain size and if they are too small, they are excluded from the index. If there are days when there is a lot of buying or selling pressure on both of these ETFs, CNDA’s index is less likely to suffer from capacity constraints (meaning that the smallest names won’t have their prices materially affected by large purchases and sells). For more explanation on “capacity” or “market impact” click here. […]