What does the effective spread capture?

The effective spread is a metric that captures both price improvement and market impact from a trader's order. It measures the difference between the executed price of a trade and the midpoint of the bid-ask spread at the time the trade is executed. When a trader receives a price that is better than the expected midpoint, this is referred to as price improvement. Conversely, if a large order affects market prices—commonly referred to as market impact—this can widen the effective spread.

By focusing on both these elements, the effective spread provides a more comprehensive view of trading costs compared to simply looking at transaction costs or broker fees. This makes it an essential measure for understanding the true cost of trading and the dynamics of liquidity in the market. Thus, the option correctly encapsulates the dual nature of the effective spread in reflecting both price improvement and the potential market impact of executed trades, illustrating its relevance in a trader's decision-making process.