The largest amount of money a strategy can run before its own market impact and liquidity constraints erode the edge to nothing.
Capacity is where backtests die. A signal worth 40 basis points a trade at $1 million is worth nothing at $200 million if the round trip costs 45 basis points in impact at that size.
Estimate it by projecting cost against size using a market-impact model and finding where net expectancy reaches zero, then running comfortably below that point. Capacity is lower in small caps, at high turnover, and at the ends of the session.
Example: gross edge is 25 basis points per round trip, and impact is estimated at 0.4 x 1.9% x sqrt(participation). Edge is exhausted when sqrt(participation) = 0.0025 / 0.0076, so participation of about 10.8% of daily volume. On a name trading $40 million a day, that caps the strategy near $4.3 million per round trip.
Original diagrams for the ideas on this page. Illustrative, not real market data.
Expectancy: the average trade. Forty trades sorted by outcome: 24 small losses and 16 larger wins. Weighting each side by how often it happens gives the average result per trade, marked here by the dashed line at +$120.
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