Your backtest equity curve is a beautiful thing. Smooth upward slope, modest drawdowns, Sharpe ratio that makes you want to frame it. Then you go live, and the market — politely but firmly — explains that historical fills were a fairy tale. The culprit most traders underestimate is market impact.

Market impact is the price movement your own order causes when it hits the book. A backtest assumes you fill at the close price or last trade. In reality, your order is part of the market. The moment you send size into a thin instrument, you push price against yourself before you've even confirmed the fill.

CONCEPTMarket impact is the cost your own order creates — separate from spread and commission, and often larger than both combined in illiquid markets.
WARNINGBacktests assume zero market impact by default. If your system trades size in low-liquidity instruments, that assumption silently inflates every performance metric.
KEY IDEASignal quality degrades as position size grows. An edge that works at $50K may statistically vanish at $500K once impact costs are honestly modelled.

The mechanics break into two components. Temporary impact is the immediate price move your order causes — it partially reverses after execution. Permanent impact is the information signal your order sends to other participants, which does not reverse. Systematic strategies that trade on predictable schedules suffer the most from permanent impact because sophisticated counterparties anticipate the flow.

Backtest vs Live: Cumulative ReturnBacktestLiveTimeReturnQ1Q3Q5

Systematic traders address this by modelling slippage explicitly during research — not as a flat per-trade assumption, but as a function of order size relative to average daily volume. Participation rate matters enormously. Trading 1% of daily volume carries very different impact than trading 15%. Execution algorithms like VWAP and TWAP exist precisely to spread orders across time and reduce that participation rate. Understanding market impact costs at the research stage, properly accounting for slippage in execution, and respecting position sizing relative to market liquidity are the three habits that separate strategies which survive scaling from those that only looked good on paper.

The backtest is the hypothesis. Live trading is the experiment. Market impact is where most hypotheses get revised — sometimes brutally.

This content is for educational purposes only and does not constitute financial product advice. Past performance is not indicative of future results. Profit Logic Ltd (ACN 688 669 936) accepts no responsibility for errors or omissions in this content or anywhere on this website. Always seek advice from a licensed financial adviser before making investment decisions.