Market Impact & Order Book

The limit order book contains resting limit orders.

These orders rest in the book and provide liquidity as they wait to be matched with nonresting orders, which represent a demand for liquidity. 

The three most common types of nonresting orders are:

- Marketable limit orders

- Market orders

- Fill-or-kill orders

 

Market Order

A market order is a demand for an immediate execution of a certain number of shares of stock at the best possible price.

To get the best possible price, a market order sweeps through one side of the limit order book - starting with the best price - matching against resting orders until the full quantity of the market order is filled or the book is completely depleted. 

 

Marketable Limit Order

Unlike a market order, a marketable limit order can be executed only at a specified price or better. 

 

The following examples illustrate how market orders to sell interact with resting limit orders to buy. 

 

The state of the limit order book establishes a pretrade equilibrium (1).  

This equilibrium which is disturbed by a market order to sell 200 shares (2).

Market orders must be filled immediately, and therefore represent a demand for liquidity. 

Sell order depletes the bid book by matching limit orders to buy --> increasingly less favorable price --> trade print (3). 

Over time, liquidity providers replenish the bid book to the posttrade equilibrium (4). 

 

The difference between (4) and (1) is an information-based effect called permanent market impact.

It is the market response to information that a market participant has decided not to own 200 shares of this stock.

This effect is typically modeled as immediate and linear in the total number of shares executed. 

 

The difference between (4) and (3) is called temporary market impact.

The trader who initiated the trade is willing to obtain a less favorable fill price (3) to get his/her trade done immediately.

This cost of immediacy is typically modeled as linear or square root.

Under this last assumption --> trade of 200 shares executed over the same period of time as a trade of 100 shares would have square root of two times more temporary impact per share. 

 

FIG 1 from book 1 encyclopedia: Algo trading! 

 

 

Fig 2 shows what would happen if the same trader were willing to wait some time between trades. 

The trade print from the previous fig. is shown as a reference point (1). 

 

A pretrade equilibrium (2) is disturbed by a 100-share market order to sell (3).

The market order depletes the bid book by matching limit orders to buy, it obtains a fill price (4).

Over time (5), liquidity providers refill the bid book with limit orders to buy.

The new posttrade equilibrium (6) < (2) because it incorporates the information of the executed market order. 

 

Our trader then places another market sell order for 100 shares (6) and obtains a trade print (7).

Over time, the temporary impact - (8) - (7) - decays and results in a new posttrade equilibrium (8).

As the permanent impact is assumed to be linear and immediate, the posttrade equilibrium is shown to be the same for one order of 200 shares as it is for two orders of 100 shares each. 

 

FIG. 2: from book 1 encyclopedia: Algo trading! 

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