Market impact is a term that is used to describe the effect that is generated when a participant in the marketplace chooses to buy or sell an asset. Depending on the current situation within the market and the type of asset involved, the impact may create very little effect, or provide the means of making a drastic change in the marketplace that ultimately affects the trading price of a number of other assets. Larger investors, such as financial institutions, will monitor market impact closely and choose to engage in buying or selling that is likely to produce the most desirable results.
In some quarters, market impact is considered closely aligned with market liquidity. This is because an investor who trades a significant amount of any asset is likely to have some sort of impact on the investment decisions of other investors, once the order is executed. In some cases, this will result in other investors quickly placing orders involving the same securities, effectively following the lead of the large investor. At other times, the market movement may be in the opposite direction as the result of the large investor’s activity.
In many instances, larger investors will attempt to measure or project the amount of market impact a given transaction is likely to generate. This is particularly important if the investor wants to achieve a particular goal with the transaction. If the idea is to successfully buy or sell certain securities without creating much attention within the marketplace, the investor may choose to forgo a single transaction and instead schedule a series of smaller transactions that are not likely to influence the buying and selling decisions of others. At the same time, if the idea is to use the transaction as a tool to trigger a specific chain of events within the marketplace, the investor may go with an order to buy or sell a sufficiently high quantity of a security in order to start the process.
Managing market impact may be important for a couple of reasons. The timing and amount of the trade may ultimately produce results that will allow the investor to increase his or her profit. For example, if the investor sells a huge lot of shares on the market, this may have a detrimental impact on the unit price. Once the price has fallen for a few months, the investor may execute a second trade to purchase a like number of those shares at the much lower price. This in turn will have the effect of driving the price upward, increasing the returns from the activity. In the interim, the investor has been able to use the proceeds from the first sale to purchase other assets that ate generating revenue, making it possible to increase the amount of returns for that period considerably.