Market impact square root law

The market impact square root law, also known as the square root rule or Almgren-Chriss law, is a concept in quantitative finance that describes the relationship between the market impact of a trade and its size. It suggests that the market impact of a trade increases proportionally to the square root of the trade size.

According to the market impact square root law, if a trader doubles the size of their trade, the market impact will increase by approximately the square root of two, which for opportunistic daytraders means an expansion of ATR by a factor of about 1.41. Similarly, if the trade size is quadrupled, the market impact or ATR expansion will increase by approximately the square root of four, which is by a factor of two. Learn how individual traders can take advantage of this and other concepts derived from algo order flow in the CEED.accelerator course modules.

This relationship is based on the assumption that market liquidity remains constant. As the trade size increases, the order starts to consume a larger portion of available liquidity, leading to a larger impact on the market price. The square root law suggests that the impact is not linearly proportional to the trade size but increases at a slower rate.

The square root law has important implications for traders and investors. It highlights the trade-off between trade size and market impact. To minimize market impact, traders can choose to split large orders into smaller orders and execute them gradually over time. By following this approach, they can mitigate the impact of their trades on market prices and potentially achieve better execution prices.

It’s worth noting that the market impact square root law is a simplified model that assumes constant liquidity and neglects other factors that can affect market impact, such as market conditions, order placement strategies, and the behavior of other market participants. Nevertheless, it provides a useful rule of thumb for understanding the relationship between trade size and market impact.