Back to course

Impact, Capacity and Turnover

Spread and fees are the same whether you trade $1m or $100m. Market impact is not: your own trading moves the price against you, the move grows with your share of the volume, and at some size it consumes the alpha entirely. That size is the strategy's capacity, and estimating it honestly is what separates a research result from an investable product.

The square-root rule of thumb

The workhorse empirical model prices the impact of executing a parent order of size QQ in a name trading average daily volume VV with daily volatility σ\sigma:

impact≈c σQV\text{impact} \approx c \, \sigma \sqrt{\frac{Q}{V}}

with cc typically near 1 for equities. The square root is the important part: doubling the order does not double the damage, it multiplies it by 2\sqrt{2}, but impact per dollar still rises with size, which is why scaling is self-limiting. Trading 1% of daily volume in a 2%-volatility stock costs roughly 2%×0.01=202\% \times \sqrt{0.01} = 20bps of impact, versus about 6bps at 0.1% participation.

The rest of this lesson is for subscribers

Unlock every lesson in Research Validation and Backtesting, and every other premium course.

Subscribe to continue

Test your knowledge

Questions are only available to subscribers.
Continue
NextSignal Decay and the Backtest-Live Gap

Keep reading Research Validation and Backtesting

21 lessons in this course, and every other premium course, on one subscription.

Subscribe now
  • Every lesson in every course, with the worked examples and interactive simulators
  • Graded questions on every lesson, with explanations for the wrong answers as well as the right one
  • The trainers, timed assessments and brainteaser library that go with them