What is market impact cost and how does NSE measure it?

Brokerage and taxes are easy to see on a contract note. This hidden cost is not. It is the extra amount you pay because your trade moves the price. This page explains what market impact cost means, how it is measured and how NSE uses it.

Quick answer

Market impact cost is the percentage difference between the price you actually get for a trade of a given size and the ideal price, usually the midpoint of the best bid and ask. It shows how liquid a share is. A low impact cost means you can trade a large amount without moving the price much. NSE uses impact cost as one of the liquidity tests for including shares in indices like the Nifty 50.

Key takeaways

• It measures how much a trade of set size moves the price.
• It is measured against the midpoint of the best bid and ask.
• A low figure means high liquidity.
• NSE uses it as a liquidity test for index inclusion.
• It is a hidden cost not shown on contract notes.

What is market impact cost?

Every share has a best buy price (bid) and best sell price (ask). The midpoint between them is the 'ideal' price. When you actually trade a certain amount, you may get a worse price, because your order eats into the order book. The difference, as a percentage, is the impact cost.

It depends on order size. A small order may have almost zero impact. A large order in the same share can have a noticeable one. That is why the figure is always stated for a given order size.

How is it calculated?

Suppose the best bid is Rs 99.90 and the best ask is Rs 100.10, so the midpoint is Rs 100. To buy shares worth Rs 10 lakh, you must take several price levels, and your average buy price works out to Rs 100.30.

The cost here is (100.30 minus 100) divided by 100, which is 0.30 percent. On a Rs 10 lakh order, that is about Rs 3,000 of hidden cost, separate from brokerage and taxes.

How does NSE use impact cost?

NSE Indices uses this measure to check liquidity when choosing shares for indices. For the Nifty 50, a share must have had an average impact cost of 0.50 percent or less for 90 percent of observations over the previous six months, for a portfolio of Rs 10 crore, among other rules.

This helps make sure index funds and ETFs that track the index can buy and sell its shares without large costs. Shares that fail the liquidity test are not eligible for the index.

Why does impact cost matter for investors?

For large investors, such as mutual funds, it can be one of the biggest trading costs. A fund that trades often in illiquid shares may lose a meaningful part of its returns to it.

For individual investors, the amounts are usually small in large company shares. But in small and illiquid shares, even modest orders can face a high cost of this kind. Checking market depth and using limit orders can help.

The key point to remember

Impact cost is the price you pay for moving the market with your own trade. It is a useful measure of liquidity and a reminder that the visible price is not always the price you will get.

The securities and commodities named here are mentioned only to explain how the market works and are not a recommendation to buy, sell or hold them.

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