Bruno Biais, Larry Glosten & Chester Spatt: How Trades Create Temporary and Permanent Price Effects

Understanding Market Microstructure and the Impact of Trading

When we look at the price of a stock, it is tempting to think that the price simply represents the underlying value of the company. However, financial markets are much more complicated. The price at which an asset is actually traded can be influenced not only by information about the company or the economy, but also by how investors trade, how much liquidity is available, and how market makers respond to buying and selling pressure.

This is the central idea behind the research of Bruno Biais, Larry Glosten, and Chester Spatt in their influential 2005 paper, “Market Microstructure: A Survey of Microfoundations, Empirical Results, and Policy Implications,” published in the Journal of Financial Markets, Volume 8, Issue 2, pages 217–264. The paper surveys a large body of market-microstructure research on how trades, quotes, liquidity, information, and market organization affect price formation.

One of the important conclusions highlighted by the authors is that trades can have both transitory and permanent effects on prices. The temporary component can arise from order-handling and inventory costs, while the permanent component is associated with information contained in trades.

This distinction gives us a much deeper understanding of why prices move after large buying or selling activity.

What Does “Price Impact” Mean?

Whenever a trade takes place, it can influence the market price.

Imagine a stock is trading at ₹100. Suddenly, a large investor wants to buy a significant number of shares. If there are not enough sellers willing to sell at ₹100, the investor may have to accept higher prices.

The investor might buy some shares at ₹100, more at ₹100.10, more at ₹100.20, and so on.

The stock may therefore move from ₹100 to ₹101 or even higher.

This movement is called price impact.

But an important question remains:

Will the price stay higher, or will it eventually move back?

This is where Biais, Glosten, and Spatt’s discussion becomes important.

Temporary Price Impact: When the Effect Fades

A temporary price impact occurs when a trade moves the price, but part of that movement disappears after the immediate trading pressure has passed.

Suppose a stock is trading at ₹100 and a large investor aggressively buys it. The buying pressure pushes the stock to ₹102.

Once the large order is completed, the intense buying pressure disappears. Other sellers enter the market, liquidity improves, and the price gradually falls back toward ₹100.50 or ₹101.

The initial movement from ₹100 toward ₹102 was therefore partly temporary.

According to Biais, Glosten, and Spatt, the literature identifies temporary price effects with factors such as order-handling costs and inventory costs.

This is an important point because it means that not every price movement caused by a large trade represents a permanent change in the value of the asset.

Sometimes the market is simply absorbing the trade.

Permanent Price Impact: When the Effect Remains

A permanent price impact is different.

Suppose a stock is trading at ₹100 and a large investor suddenly begins buying aggressively. Other market participants may ask why.

Perhaps the investor has information suggesting that the company’s future earnings will be much stronger than the market currently expects.

Other traders may interpret the buying activity as information.

As they update their expectations, they also begin buying.

The stock rises to ₹105 and remains around that level.

In this situation, the price movement is more persistent because the market has incorporated information into the price.

Biais, Glosten, and Spatt explain that the permanent component of trade impact reflects information, while the temporary component is related to trading frictions such as order-handling and inventory costs.

Why Can a Trade Contain Information?

One of the most important ideas in market microstructure is that trading itself can reveal information.

Imagine that a large institutional investor suddenly purchases a substantial quantity of a stock.

Other market participants do not necessarily know why the investor is buying.

The investor might simply be rebalancing a portfolio.

But they might also have information suggesting that the stock is undervalued.

Because other traders cannot immediately observe the reason behind the order, they may learn from the trading activity itself.

If the buying appears informed, other investors may adjust their expectations and the stock price may move permanently.

This is one reason market microstructure studies the relationship between trades and prices, rather than looking only at company fundamentals.

The Role of Liquidity

Liquidity is another major part of the story.

A highly liquid market has many buyers and sellers willing to transact close to the current price.

A less liquid market has fewer available orders.

Imagine two markets.

In the first market, thousands of shares are available for sale around ₹100.

A large buyer can purchase a significant quantity without moving the price very much.

In the second market, only a small number of shares are available around ₹100. A large buyer may have to accept progressively higher prices.

The same-sized trade can therefore have a very different price impact depending on market liquidity.

This is why market microstructure is concerned with the costs of trading and the process through which transaction prices converge toward longer-term values.

Order-Handling Costs and Inventory Costs

Biais, Glosten, and Spatt’s survey discusses several mechanisms through which trading creates price effects.

One is order-handling costs. Market makers and liquidity providers incur costs when processing and executing orders. These costs can be reflected in transaction prices and bid-ask spreads.

Another is inventory costs.

A market maker who sells shares to a buyer now holds fewer shares—or potentially a larger position if the transaction is in the opposite direction. That position exposes the market maker to price risk.

For example, if a market maker buys a large number of shares from sellers, the market maker now holds inventory that could lose value if the stock price falls.

These risks influence how liquidity providers quote prices.

The authors’ survey highlights order-handling costs, inventory costs, and adverse-selection costs as important components of the economics of trading and price formation.

Adverse Selection: When One Side Knows More

Another important concept discussed by the authors is adverse selection.

Imagine that a trader wants to buy a stock from a market maker.

The market maker does not know whether the trader is simply trading for portfolio reasons or whether the trader has valuable private information.

If the trader is informed and knows that the stock is worth more than its current price, the market maker may be selling at an unfavorable price.

Because liquidity providers face this possibility, they may demand compensation for taking the other side of trades.

This can affect the bid-ask spread and the price at which transactions occur.

In this way, information asymmetry can become part of the cost of providing liquidity.

Why Large Trades Can Have a Stronger Effect

The size of a trade can also matter.

A small trade may be easily absorbed by the market.

A very large trade can consume a substantial amount of available liquidity and therefore have a greater immediate effect on prices.

But trade size can also contain information.

A market participant might reasonably ask:

Why would someone want to buy such a large amount?

If the order appears unusually large or urgent, other traders may interpret it as a signal.

Therefore, a large trade can potentially have both:

a temporary liquidity effect, because it consumes available liquidity,

and

a persistent information effect, because other traders learn from the order.

This is why price impact cannot always be explained by a single factor.

A Simple Example

Imagine that a stock is trading at ₹500.

A large institution decides to buy 1 million shares.

The available sellers near ₹500 are not sufficient to satisfy the order.

The institution therefore continues buying at ₹500.20, ₹500.50, ₹501, and higher.

The stock reaches ₹503.

At this point, the institution completes its purchase.

If the price falls back to ₹500.50 after the buying pressure disappears, much of the original movement was temporary.

But suppose the stock remains around ₹503 because other investors believe that the institution’s aggressive buying contained valuable information.

Then part of the movement may be permanent.

The actual price impact of the trade therefore contains both components.

Why This Matters for Traders

This research is particularly relevant for anyone trying to understand large market movements.

A trader might see a stock suddenly move upward after a large buy order and conclude:

“Someone knows something.”

But that conclusion may be too simple.

The price may have moved because the trade consumed available liquidity.

Alternatively, the trade may genuinely contain information.

Or, as often happens in real markets, both mechanisms may operate simultaneously.

Understanding this distinction helps traders avoid assuming that every sharp movement represents a fundamental change in value.

Why This Matters for Institutional Investors

The distinction is even more important for large institutional investors.

A pension fund or mutual fund may need to buy a very large number of shares.

If it executes the entire order immediately, the buying pressure can push the price higher before the institution completes its purchase.

The institution therefore faces a trade-off.

Trading quickly reduces the risk that the market moves away before the order is completed, but it can increase market impact.

Trading slowly may reduce the immediate price impact, but the market may move for other reasons while the order is being executed.

This is why institutional trading involves careful decisions about execution speed, liquidity, order size, and market conditions.

Market Microstructure Looks Inside the Market

Traditional asset-pricing models often focus on questions such as:

What should this company be worth?

Market microstructure asks a different set of questions:

Who is buying?

Who is selling?

How large are the orders?

How much liquidity is available?

What information might traders possess?

How do market makers respond?

How does the structure of the market affect prices?

Biais, Glosten, and Spatt describe market microstructure as the study of the economic forces affecting trades, quotes, and prices, including how transaction prices converge toward or deviate from longer-term fundamental values.

This perspective helps explain why the price observed on a trading screen can temporarily differ from an asset’s longer-term fundamental value.

The Bigger Picture: Prices Are Not Created by Information Alone

One of the most important lessons from this research is that price formation is a process.

Information matters.

But liquidity also matters.

Order-handling costs matter.

Inventory positions matter.

Market power matters.

The behavior of liquidity suppliers matters.

And the structure of the trading venue matters.

The authors’ survey shows how these different forces interact to influence transaction costs, price impact, price discovery, and market efficiency.

This means that when we observe a price moving sharply, we should not automatically assume that the underlying fundamental value has changed by the same amount.

Part of the movement may disappear.

Part may remain.

Understanding that distinction is one of the central insights of market microstructure.

Conclusion

The research by Bruno Biais, Larry Glosten, and Chester Spatt provides a useful framework for understanding why trades affect prices. Their 2005 survey of market-microstructure research explains that trades can have both temporary and permanent price impacts. Temporary effects can arise from order-handling and inventory costs, while permanent effects are associated with information being incorporated into prices.

The key lesson is that a price movement following a trade does not necessarily mean that the asset’s fundamental value has changed permanently. Some of the movement may simply reflect the immediate pressure created by the transaction and the available liquidity in the market.

At the same time, trades can reveal information. When other investors learn from trading activity, the resulting price change can persist.

Therefore, the market price we see is the result of a continuous interaction between information, liquidity, trading decisions, and market structure.

In simple terms, a trade can move the price temporarily because it changes the balance of supply and demand, but it can also move the price permanently when the trade reveals information that changes what the market believes the asset is worth.

Research Reference

Biais, Bruno, Larry Glosten, and Chester Spatt (2005). “Market Microstructure: A Survey of Microfoundations, Empirical Results, and Policy Implications.” Journal of Financial Markets, 8(2), 217–264. DOI: 10.1016/j.finmar.2004.11.001.