In financial markets, market impact is the effect that a market participant has when it buys or sells an asset. It is the extent to which the buying or selling moves the price against the buyer or seller, i.e. upward when buying and downward when selling.
Especially for large investors, e.g. financial institutions, market impact is a key consideration that needs to be considered before any decision to move money within or between financial markets. If the amount of money being moved is large (relative to the turnover of the asset(s) in question), then the market impact can be several percentage points and needs to be assessed alongside other transaction costs (costs of buying and selling).
Market impact can arise because the price needs to move to tempt other investors to buy or sell assets (as counterparties), but also because professional investors may position themselves to profit from knowledge that a large investor (or group of investors) is active one way or the other. Some financial intermediaries have such low transaction costs that they can profit from price movements that are too small to be of relevance to the majority of investors.
The financial institution that is seeking to manage its market impact needs to limit the pace of its activity (e.g. keeping its activity below one third of daily turnover) so as to avoid disrupting the price.
Suppose an institutional investor places a limit order to sell 1,000,000 shares of stock XYZ at $10.00 per share. Now a professional investor may see this, and place an order to short sell 1,000,000 shares of XYZ at $9.99 per share.
- Stock XYZ rises in price to $9.99 and keeps going up past $10.00. The professional investor sells at $9.99 and covers his short position by buying from the instituational investor. His loss is limited to $0.01 per share.
- Stock XYZ rises in price to $9.99 and then comes back down. The professional investor sells at $9.99 and covers his short position when the stock declines. The professional investor can gain $.10 or more per share with very little risk. The institutional investor is unhappy, because he saw the market price rise to $9.99 and come back down, without his order getting filled.
Effectively, the institutional investor's large order has given a option to the professional investor. Insitutional investors don't like this, because either the stock price rises to $9.99 and comes back down, without them having the opportunity to sell. Or, the stock price rises to $10.00 and keeps going up, meaning the institutional investor could have sold at a higher price.