What are the components of market impact cost?

Question

AcadiFi · Accepted Answer

Market impact is the adverse price movement caused by your own trading. It decomposes into **permanent impact** (information content that moves equilibrium) and **temporary impact** (liquidity consumption that reverts).

**Permanent impact**: the market infers that your order carries information (e.g., a large buy suggests someone knows something). Even after your trading stops, the price stays elevated because expectations have updated. Magnitude is typically 30–50% of total impact for informed-looking flow.

**Temporary impact**: liquidity providers demand compensation for taking the other side. As you consume the book, quotes back away. Once you stop, market makers replenish and the price partially reverts. This piece is sometimes called 'liquidity cost'.

Formula-style decomposition: Impact = Permanent + Temporary. If post-trade price drifts back to halfway, roughly equal halves; if no reversion, pure permanent; if full reversion, pure temporary.

Example: trader Kalani Kawena executes a $40m buy in a mid-cap over 90 minutes. Arrival $27.00; last fill $27.35; one hour post-completion $27.22. Total impact $0.35; permanent $0.22 (the fraction that didn't revert); temporary $0.13.

**Drivers of magnitude**:

- Size relative to average daily volume (ADV) — the most important factor.
- Volatility — higher vol widens spreads and amplifies impact.
- Urgency — fast trading raises temporary impact dramatically.
- Information content — trades tied to analyst-driven calls often leak information, raising permanent impact.

**Managing it**:

- Break orders into smaller clips.
- Use multiple venues including dark pools to reduce signaling.
- Trade during liquid windows.
- Use IS-aware algos that balance impact against timing risk.

FRM candidates should recognize this decomposition because Kyle's lambda and the square-root impact law build directly on it.

What are the components of market impact cost?

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