Technology has made trading easy as pie attracting millennials. But, before you throw yourself into the trading ring, you need to understand a few important concepts that affect trade. Market liquidity is one such concept.
In general, liquidity is how quickly an asset can be exchanged for cash.
When it comes to the stock market, liquidity is how quickly a security transaction occurs in the marketplace. It means how easily a security can be transacted without incurring a high transaction cost to the trader. The high cost here is the impact cost that a trader has to incur due to the lack of liquidity. (Click here to know when the security is said to be liquid or illiquid)
Impact cost is the measure of liquidity of the security. It is the cost a buyer or seller has to incur for a particular quantity of order at a given point of time due to the existing liquidity condition of the security available in the market.
The availability of buyers and sellers determines the liquidity of a market. More the buyers and sellers, the quicker the transaction. Then, the security is said to be liquid.
On the other hand, if the buyers and sellers are sparse for security, it takes longer for the trade to execute making the security illiquid.
Impact cost is an efficient measure to gauge the liquidity of a security. The higher the impact cost, the lower is the liquidity.
Note: The impact cost is a hidden cost different from the fixed transaction cost. The fixed transaction cost you see in your contract note typically includes brokerage, security transaction tax, GST, and other charges.
Let us look into an example of how impact cost is calculated and how it helps a trader to determine the true cost of execution of trade in comparison to the bid-ask spread
Consider the following order book for a stock ‘X’ at a point in time.,
|Sr no||Quantity||Price(Rs)||Price (Rs)||Quantity||Sr no|
There are four buy and sell orders lying in the order book. If a buyer wants to buy 100 shares of X, it would be matched against the best available sell order at Rs 14, i.e. he would get 100 shares at Rs 14 per share. If a seller wants to sell 100 shares of X, it would be matched against the highest available buy order at Rs 13.5, i.e. the shares would be sold at Rs 13.5 per share.
In the above scenario, the bid-ask spread is Rs 0.5. Hence, if a person buys 100 shares and sells them immediately, he is losing due to the bid-ask spread. The bid-ask spread here is considered as the impact cost a trader has to incur. In the above example, the bid-ask spread of Rs 0.5 is valid for an order size of up to 1000 shares.
For order sizes of more than 1000, the impact cost becomes different from the bid-ask spread for the above example.
Impact Cost is calculated using the following formula,
Impact cost (for a particular quantity) = (Actual Buy / Sell Price – Ideal Price ) ÷ Ideal Price x 100
Ideal Price = ( Best Buy Price + Best Sell Price ) ÷ 2
Actual Buy / Sell Price = Sum of ( Quantity x Execution Price ) ÷ Total Quantity
Case 1: If a trader wants to buy 3000 shares of X,
Ideal Price = ( Rs 13.5 + Rs 14 ) ÷ 2 = Rs 13.75
Actual Buy Price = (14 x 1000 + 14.5 x 1500 + 13.7 x 7500) ÷ 3000 = Rs 14.2
Impact cost for 3000 shares = ( 14.2 – 13.75 ) ÷ 13.75 = 0.0327 x 100 = 3.27%
The impact cost faced for buying 3000 shares of X is 3.27% more than the ideal transaction price.
Case 2: Now , if a trader wants to sell 3000 shares of X,
Ideal Sell Price = ( Rs 14 + Rs 13.5 ) ÷ 2 = Rs 13.75
Actual Sell Price = ( 13.5 x 1000 + 13.4 x 1000 +13.1 x 1000 ) ÷ 3000 = Rs 13.3
Impact Cost = ( 13.3 – 13.75 ) ÷ 13.75 = 0.0303 x 100 = 3.03%
The impact cost faced for selling 3000 shares of X is 3.03% less than the ideal transaction price.
Calculating impact cost each time is a tedious task for a trader. NSE and BSE provides a ready reckoner of impact cost for securities.
Click here to find the list of securities listed on NSE and their impact cost for the month.
Click here to find the list of securities listed on BSE and their impact cost.
Now that you have caught up on the impact cost definition and calculation, it’s time to get to know some key features of impact cost:
- Impact cost is separately computed for buy and sell
- Impact cost may vary for different transaction sizes
- Higher the impact cost or bid-ask spread, lower the liquidity, and vice versa
Here on, if you find a security with a low impact cost, you can conclude that the buyers and sellers are present in the market looking for buying and selling opportunities. The high impact cost of a security signifies the lack of liquidity translating into a high cost for buyers and sellers.
Investors out there, plan your trade carefully considering the concept you have learned just now. Happy trading!!