Overview
Market impact is the tendency of market prices to be influenced by a trade. That is, when a large order is being traded in the market, it will push the price.
Modeling Market Impact
When backtesting a trading strategy, it is generally advisable not to take the price history of the assets involved as given and just run the strategy, particularly if the trade sizes are large. Rather, the trade strategy is likely to have pushed the price obtained in the market in a non-favorable direction, making the backtest an optimistic estimate of profits.
Most asset managers will try to incorporate a model of market impact in their backtesting strategy.
The two choices that need to be made when modeling market impact are
- The size of the impact, given the volume of trades
- Whether the impact is temporary or permanent and how long it takes for a temporary impact to revert.