Analyzing Market Impact – Does Your Trading Affect the Wider Market

This article was written by David Mercer, CEO of LMAX Exchange.

One of the key metrics you need to consider in your choice of Liquidity Liquidity The term liquidity refers to the process, speed, and ease of which a given asset or security can be converted into cash. Notably, liquidity surmises a retention in market price, with the most liquid assets representing cash.The most liquid asset of all is cash itself.· In economics, liquidity is defined by how efficiently and quickly an asset can be converted into usable cash without materially affecting its market price. · Nothing is more liquid than cash, while other assets represent The term liquidity refers to the process, speed, and ease of which a given asset or security can be converted into cash. Notably, liquidity surmises a retention in market price, with the most liquid assets representing cash.The most liquid asset of all is cash itself.· In economics, liquidity is defined by how efficiently and quickly an asset can be converted into usable cash without materially affecting its market price. · Nothing is more liquid than cash, while other assets represent Read this Term and transaction cost analysis is market impact. Or put simply, the effect your trading has on the wider market post trade. Rather simplistically you are told that, if the market moves a lot in reaction to your trading, then that’s a bad thing and you pay wider spreads with a high cost of rejection and higher response times.

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But, if you trade on ‘last look’ prices, lower market impact would mean you benefit from tighter spreads and lower cost of rejections and hold times. Let’s take a deeper look at this. The easy one first - if your flow is benign and looks a bit like this:

and you trade on firm liquidity, the cost of rejection and hold time should be close to zero. The same should also be true on ‘last look’ venues, if it isn’t, then you must add those costs to your spread and commission calculations. What if your flow is more informed, and lo and behold, even profitable? Your flow may look like this:

and the next question is, do you actually desire market impact? If you’re a day trader, I would argue yes. Your key considerations then should be fill rates and any cost of hold times or rejection. It is obvious in this case that firm liquidity with much higher fill rates and lower cost of hold time and zero cost of rejection is better for you. However, it is unlikely that you will see the tighter spread available and you’re probably happy to pay a higher spread in exchange for greater certainty of Execution Execution Execution is the process during which a client submits an order to the brokerage, which consequently executes it resulting in an open position in a given asset. The execution of the order occurs only when it is filled. There is typically a time delay between the placement of the order and the execution which is called latency.In the retail FX space, reliable brokers always strive to deliver best execution to their clients in order to maintain a solid business relationship with them. This is a co Execution is the process during which a client submits an order to the brokerage, which consequently executes it resulting in an open position in a given asset. The execution of the order occurs only when it is filled. There is typically a time delay between the placement of the order and the execution which is called latency.In the retail FX space, reliable brokers always strive to deliver best execution to their clients in order to maintain a solid business relationship with them. This is a co Read this Term.

Conversely, if you’re a real money hedger, then you may want to adjust your style of trading so as not to create too much market impact and benefit from tighter spreads – as this will form a high proportion of your hedging costs in the long term.

The reality is that your flow most likely sits between these two extremes, and your choice is not simple. You need to weigh up spreads, fill rates, cost of rejection, cost of hold time and price improvement.