Today has been an interesting day regarding the market impact and how despite huge volumes a large order can potentially move markets. For many of you like my other “101s”, this will be obvious but for others, it is probably new.
Every order has a transaction cost to get executed. It may be just selling on the bid side of the market. It may be selling on the bid side plus commission and it may be pushing the equilibrium price in order to move large size the last bit is the focus of this thread.
In order to move large size transferring your risk to someone else, you have to offer a concession. Essentially a discount to the equilibrium price when selling a large block. That discount encourages players who were perfectly fine with their pre-existing positions to buy.
Their expectation is that some or all of the discount will be captured if they hold your block longer than you were willing to hold it. Market makers and other temporary liquidity providers are constantly seizing on these discounts. It’s fairly competitive, that’s the discount part. However, MM’s are wary of buying a large block at a discount if they expect you have another large block to sell right after they buy the first one. You also are wary of disclosing your complete hand (picture is the lingo). Also, you may have alpha.
Meaning those who take the opposite side of your trades on average lose money because when you sell you are usually right. For that reason information about who is selling and the actual size of the order is extremely valuable and any information slippage can increase the discount. So there are all sorts of ways to get prevent information slippage and to execute orders in ways to minimize the discount. Nonetheless, even the best of the best will still see a discount if they want to move more volume than the market can take.
For three decades I have helped clients at Salomon minimize transaction costs and for my time on the buy side always been concerned about market impact and cost. I am not alone!!!
Every serious money manager regardless of the type of manager is focused on trading with low market impact. Trading desks at institutional buy-side clients are judged and compensated by their firms based on the costs of trading. Needless to say, the area is quite well studied.
Most firms collect data of every order they do in every asset class and specific security. Data sciences then allow them to understand exactly what they should expect to pay in market impact for every security they trade in every size and order timing.
These multi-dimensional curves can even be extrapolated for large sizes than they have had experience in doing by using related experience in other securities where they have traded large sizes. Then every trade can be judged based on the ex-anti estimate and the ex-post result. That analysis is then incorporated into the data and the curves are iterated. Every big client of Salomon and every hedge fund I know of uses some sort of analysis of this type to trade. It’s the price of admission to play in this business