It should however be emphasised that :
(a) impact cost is separately computed for buy and sell
(b) impact cost may vary for different transaction sizes
(c) impact cost is dynamic and depends on the outstanding orders
(d) where a stock is not sufficiently liquid, a penal impact cost is applied
When a buyer or seller approaches the market with an intention to buy a particular stock, he can execute his buy order in the stock against such sell orders, which are already lying in the order book, and vice versa.
An example of an order book for a stock at a point in time is detailed below:
There are four buy and four sell orders lying in the order book. The difference between the best buy and the best sell orders (in this case, Rs.0.50) is the bid-ask spread. If a person places an order to buy 100 shares, it would be matched against the best available sell order at Rs. 4 i.e. he would buy 100 shares for Rs. 4. If he places a sell order for 100 shares, it would be matched against the best available buy order at Rs. 3.50 i.e. the shares would be sold at Rs.3.5.
Hence if a person buys 100 shares and sells them immediately, he is poorer by the bid-ask spread. This spread may be regarded as the transaction cost which the market charges for the privilege of trading (for a transaction size of 100 shares).
Progressing further, it may be observed that the bid-ask spread as specified above is valid for an order size of 100 shares upto 1000 shares. However for a larger order size the transaction cost would be quite different from the bid-ask spread.
Suppose a person wants to buy and then sell 3000 shares. The sell order will hit the following buy orders:
while the buy order will hit the following sell orders :
This implies an increased transaction cost for an order size of 3000 shares in comparison to the impact cost for order for 100 shares. The "bid-ask spread" therefore conveys transaction cost for a small trade.
This brings us to the concept of impact cost. We start by defining the ideal price as the average of the best bid and offer price, in the above example it is (3.5+4)/2, i.e. 3.75. In an infinitely liquid market, it would be possible to execute large transactions on both buy and sell at prices which are very close to the ideal price of Rs.3.75. In reality, more than Rs.3.75 per share may be paid while buying and less than Rs.3.75 per share may be received while selling. Such percentage degradation that is experienced vis-à-vis the ideal price, when shares are bought or sold, is called impact cost. Impact cost varies with transaction size.
For example, in the above order book, a sell order for 4000 shares will be executed as follows:
|Wt. average price||3.43|
The sale price for 4000 shares is Rs.3.43, which is 8.53% worse than the ideal price of Rs.3.75. Hence we say "The impact cost faced in buying 4000 shares is 8.53%".
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