What is the Impact cost & How it is related to Liquidity?

by John Smith Stock Market Investor

Before diving deep into the Impact cost, we must first understand the concept of liquidity as it is the sole factor to decide the Impact cost for a buyer or seller while executing an order (buy or sell).

Liquidity refers to the ease with which any market participant, either buyer or a seller, is able to execute his/her order in a free marketplace without affecting the current market price of the stock at the time of initiating a transaction.

Watch: What Is Market Liquidity?

In other words, liquidity defines the extent to which an asset can be transacted and quickly converted into cash without much of a negotiation. This is only possible when there are a large number of buyers and sellers present in the same market at the same time. To sum it up, the higher number of buyers and sellers means higher liquidity and lower number of buyers and sellers means poor liquidity.

What liquidity means in the context of the stock market?

In the context of the stock market, it means how easily a large quantity of shares or any other underlying asset can be transacted without incurring a high cost. Now high cost here does not mean transaction charges such as depository charges, brokerage, turnover charges, taxes etc. Here the cost is referred to the one which is incurred due to lack of liquidity, i.e. the Impact cost.

So what exactly is Impact cost?

Impact cost is the cost which the buyer or a seller incurs due to the existing liquidity condition of the market while executing their respective order. It represents the cost of executing the predefined quantity of shares with respect to the availability of buyers and sellers at that given point of time.

Impact cost is an efficient and realistic measure to gauge the liquidity in the market at any specific point of time. In a highly liquid market, it is closer to the true cost of execution faced by traders in comparison to the bid-ask spread.