Execution and Market Microstructure

Market microstructure is the study of how trading mechanics shape prices. Three key concepts:

The limit order book lists all unexecuted bids and asks at each price level. Market orders consume the book; limit orders add to it. The best bid and best ask form the visible spread.

Slippage is the cost of executing a large order: by walking up (or down) the book, you trade at progressively worse prices. Square-root market impact $\Delta P \propto \sqrt{Q/V}$ is a common empirical scaling — doubling order size only increases impact by $\sim 40\%$, not $100\%$.

Execution algorithms (TWAP, VWAP, implementation shortfall, adaptive arrival-price) split a large parent order into many child orders timed and sized to minimize impact. Modern execution increasingly uses ML to predict short-horizon price moves and adapt order placement.

Bottom line: in liquid markets, signal alpha must be evaluated net of expected execution cost. A signal worth $5$ bps on paper but costing $4$ bps to capture isn't real edge.