Impact cost
Also written Market impact cost
The percentage by which a market order's actual execution price degrades against the ideal price — the mid-point of the best bid and the best offer — and so the real cost of trading in size.
In plain language
Everybody quotes "the price" of a stock as a single number. There is no single number. There is a price at which somebody is willing to buy from you and a slightly higher price at which somebody is willing to sell to you, and behind each of those sits only a limited quantity.
The ideal price is the mid-point of the best buy and the best sell order — the fiction of a single price. Impact cost measures how far your actual fill lands from that fiction, as a percentage.
Buy a small quantity and you pay close to the ideal price. Buy a large one and you exhaust the best offer, then the next, then the one after, each worse than the last. Your average fill drifts away from the ideal price, and the percentage drift is the impact cost. Nobody invoices you for it. It is a cost all the same.
How it works
Three properties matter, and all three are examined.
Impact cost varies with transaction size. It is not a property of the stock alone; a stock can have a trivial impact cost for 500 shares and a punishing one for 50,000.
It is different on the buy side and the sell side, because the buy and sell halves of the order book are not mirror images of each other.
It is a measure of liquidity, and it moves opposite to it. A liquid market is one where large orders execute without moving the price, so high liquidity means low impact cost. It is also the reason a wide bid-ask spread and a high impact cost travel together: the larger the spread, the larger the impact cost.
The bid-ask spread is the special case of impact cost for the smallest trade — the one that fits entirely inside the best quote.
The formula
Ideal price = (Best bid price + Best ask price) ÷ 2
Actual price = Quantity-weighted average price of the orders your trade consumes
Impact cost = (Actual price − Ideal price) ÷ Ideal price × 100
For a sell order the numerator becomes Ideal price − Actual price; the degradation is always measured as a positive cost.
A worked example
The order book for a mid-cap stock at a moment in time:
| Buy qty | Bid (Rs) | Ask (Rs) | Sell qty |
|---|---|---|---|
| 800 | 482.50 | 483.50 | 600 |
| 1,200 | 481.90 | 484.20 | 1,400 |
| 2,000 | 481.20 | 485.00 | 3,000 |
Ideal price = (482.50 + 483.50) ÷ 2 = Rs 483.00
Buying 2,000 shares at market. The order takes all 600 at 483.50, then 1,400 at 484.20:
Actual price = (600 × 483.50 + 1,400 × 484.20) ÷ 2,000
= (2,90,100 + 6,77,880) ÷ 2,000 = Rs 483.99
Impact cost = (483.99 − 483.00) ÷ 483.00 × 100 = 0.20%
In rupees = (483.99 − 483.00) × 2,000 = Rs 1,980
Now buy 5,000 shares instead. The order runs three levels deep:
Actual price = (600 × 483.50 + 1,400 × 484.20 + 3,000 × 485.00) ÷ 5,000
= Rs 484.60
Impact cost = (484.60 − 483.00) ÷ 483.00 × 100 = 0.33%
In rupees = (484.60 − 483.00) × 5,000 = Rs 7,980
Two and a half times the order size, four times the rupee cost. The brokerage on both trades is the same percentage; the impact cost is not, and on the larger order it dwarfs it.
The workbook's own illustration uses the same arithmetic on a cheaper stock: to buy 1,500 shares with a best bid of 9.80 and a best ask of 9.90, the ideal price is Rs 9.85, the actual price is (1,000 × 9.90 + 500 × 10.00) ÷ 1,500 = Rs 9.9333, and the impact cost is 0.84%.
Why NISM asks about it
Chapter 2 (Understanding Index), section 2.4 on the attributes of an index, introduces impact cost — because an index is only investable if its constituents can be traded in size, so low impact cost is a selection criterion for index stocks. Chapter 6, section 6.5, returns to it as one of the three classes of trading cost, alongside user charges and statutory charges. The two questions that recur are the computation above and the true/false statement "impact cost is low when liquidity in the system is high" — which is true.
Common exam traps
- Impact cost and the bid-ask spread are not paid to anyone. They are not charges. The workbook groups them separately from user charges and statutory charges for exactly this reason, and asks which cost "is not actually paid by market participants".
- It is measured against the ideal price, not against the best bid or the best ask. Using the best ask as the benchmark for a buy order gives a smaller, wrong answer.
- High liquidity means low impact cost. The relationship is inverse, and the sentence reads naturally either way, which is why it is asked.
- The buy-side and sell-side figures differ. Do not compute one and assume the other.
- A limit order avoids impact cost but risks non-execution. Impact cost is the price of demanding immediacy with a market order.
- Impact cost rises with order size, so quoting "the impact cost of stock X" without a transaction size is meaningless.
Where this is taught
- Series XII · Chapter 4: Secondary Marketsintroduced here
- Series VIII · Chapter 2: Understanding Indexintroduced here
- Series X-A · Chapter 8: Investing in Stocksintroduced here
- Series IV · Chapter 3: Exchange Traded Interest Rate Futuresintroduced here
- Series XVI · Chapter 6: Trading Mechanismintroduced here
- Series XXI-B · Chapter 3: Investing in Stocksintroduced here
- Series V-D · Chapter 14: Understanding Indexintroduced here
- Series XIX-C · Chapter 10: Introduction to Indices and Benchmarkingintroduced here
- Series XIX-E · Chapter 8: Indices and Benchmarkingintroduced here
- Series VII · Chapter 4: Risk Managementintroduced here
- Series IV · Chapter 5: Strategies using Interest Rate Derivatives
- Series XXI-B · Chapter 12: Introduction to Indices
- Series VIII · Chapter 6: Trading Mechanism
Related terms
- Liquidity riskThe risk of being unable to get out of a position at or near the quoted price — because the contract is bilateral, because the order book is thin, or because volumes dry up near expiry.
- LiquidityThe degree of ease with which you can turn an investment back into cash at a fair value — one of the three pillars of investing, alongside safety and return.
- Bid-ask spreadThe gap between the best buy (bid) price and the best sell (ask) price in the order book — the cost a trader bears for buying and immediately selling a small quantity.
- Ideal priceThe average of the best bid and the best offer price in the order book — the benchmark against which impact cost is measured, and the price you would get in an infinitely liquid market.
- IndexA statistical indicator that tracks a portfolio of securities representing a market or part of it, expressed as a change from a base value — so the percentage move matters, not the number itself.
- Market orderAn order to buy or sell a contract at the best price currently available in the market — no price is specified, so it trades immediately against the opposite side of the order book.
- Execution riskThe risk that a trade does not execute as planned — that prices move between the legs of a strategy, that one leg fails to fill, or that an order fills away from the desired price.
- MSCI India IndexMSCI's index of the large and mid-cap segments of Indian equity — 86 constituents covering about 85% of market capitalisation per the workbook — built for consistent cross-country comparison.
- Tick sizeThe smallest price change a contract may be quoted in — prices move only in whole multiples of it, and it differs from one commodity to another.
- Rebalancing costsThe transaction cost and the tax cost a portfolio incurs when it is brought back to its target weights — weighed, in the workbook's framing, against the cost of not rebalancing at all.
- Unbiased EstimateThe technical definition of an efficient market price: the market price is an unbiased estimate of a security's true value, so deviations are random rather than one-sided.
- Securities Transaction TaxA central government tax collected by the exchange on the sell side of every futures and option trade — 0.05% of futures traded value, 0.15% of option premium, and 0.15% of settlement price on exercise.
- Limit orderAn order to buy or sell a contract at a specified price or better — lower for a buy, higher for a sell — which waits in the order book if it cannot be matched at once.
- median quarter-sigma order sizeA liquidity eligibility test for stock derivatives — the median order size, over six months, needed to move the stock price by a quarter of a standard deviation — which must be at least Rs 75 lakh.