Price Impact & Market Depth
When you place a small order (1 share), you pay the quoted price. When you place a large order (100,000 shares), you move the price. This is called Price Impact.
Why does Price Impact happen?
It happens because liquidity is not infinite at the best price. You have to "Walk the Book".
Example: Walking the Book
Current Ask Side:
- Level 1: 100 shares @ ₹50.00
- Level 2: 200 shares @ ₹50.10
- Level 3: 500 shares @ ₹50.50
You want to buy 800 shares.
- You buy 100 @ 50.00. (Cheap)
- You clean out Level 1.
- You buy next 200 @ 50.10. (More expensive).
- You buy remaining 500 @ 50.50. (Most expensive).
Result:
- You pushed the price from 50.00 to 50.50.
- Your Average Price is significantly higher than 50.00.
- The difference between intended price (50.00) and avg execution price is Slippage.
Kyle's Lambda (Measuring Impact)
In 1985, Pete Kyle proposed a model to measure market depth. The slope of price impact is called Kyle's Lambda.
- Formula (Concept): Price Change = Lambda * Order Flow
- High Lambda: Illiquid market. Small buy order causes huge price jump.
- Low Lambda: Liquid market. Massive buy order barely moves price.
The Liquidity Paradox: Liquidity is often there when you don't need it, and disappears when you need it most (e.g., during a crash). Price impact becomes extreme during panic selling.
Managing Price Impact
Institutional traders cannot just dump 1 million shares. They use Execution Algorithms (like VWAP, TWAP, Iceberg) to split the big order into tiny "child orders" to hide their footprint and minimize impact.
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