Effective Spread Decomposition (Realized vs. Price Impact)
The Formal Definition
An econometric trade execution quality framework that decomposes the effective bid-ask spread into two distinct components: the Realized Spread (the actual profit captured by the market maker after adverse market movement) and Price Impact (the permanent information leakage and market displacement caused by the trade).
Effective Spread = Realized Spread (Dealer Profit) + Price Impact (Information Leakage) = 2 × |P_trade - Mid_initial|
Cole Barrett's Reality Check
The Unvarnished Bottom Line"When you execute a trade, you pay an effective spread. But where does that money go? Effective spread decomposition breaks the spread in half. One half is the 'realized spread'—the pure profit the market maker gets to keep in their pocket. The other half is 'price impact'—how much your own order pushed the market around. If price impact is high, you are tipping your hand to the market; if realized spread is high, your broker is overcharging you for liquidity."
Interactive Simulator: Test the Math
Real-World Example: Scenario Breakdown
Examining the real numbers for: Decomposing execution quality across 10,000 retail market orders executed by an institutional wholesale dealer
| Execution Metric | Non-Toxic Retail Flow (Wholesaler Profit Haven) | Informed Institutional Flow (Adverse Selection) |
|---|---|---|
| Fee / Rate | $0.00 'free' trades | Institutional clearing tier |
| Spread / Buffer | Effective Spread: $0.04 | Price Impact: $0.005 | Realized Spread: $0.035 | Effective Spread: $0.04 | Price Impact: $0.038 | Realized Spread: $0.002 |
| Execution / Status | Order caused virtually zero market displacement after execution | Market immediately moved in trade's direction by 3.8 cents post-execution |
| Total Cost / Result | Proves retail order flow is non-toxic and highly profitable for internalizers | Demonstrates high price impact on toxic institutional orders |
How Brokers Weaponize This Term
Wholesale market makers cite large effective spread price improvement to retail clients while concealing that their realized spread profits on uninformed retail flow are significantly higher than on public exchange flow.
Broker Evaluation Matrix
Cole Approves
Interactive Brokers: Provides institutional Transaction Cost Analysis (TCA) reports that decompose client executions into Realized Spreads and Price Impact against 5-minute post-trade benchmarks.
Read Audit →Cole Flags / Avoids
Zero-Fee PFOF Desks: Hides realized spread metrics in mandatory SEC filings, presenting only superficial price improvement averages on customer statements.
View Trap Details →Frequently Asked Questions
What does a negative realized spread mean for a market maker?
It means the market maker lost money on the trade; the price moved so fast against them after filling the order that their inventory was liquidated at a net loss.
What post-trade time horizon is standard for calculating realized spread in SEC Rule 605?
Historically 5 minutes, but modern updated SEC Rule 605 standards require measuring realized spreads at multiple granular intervals, including 15 seconds and 1 minute post-trade.