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.