Market impact refers to what happens when our trading strategy is deployed to live markets as compared to when it is not. This is basically to quantify and understand the reactions of other market participants in response to our order flow. Market impact is difficult to anticipate and simulate, and gets progressively worse the more the trading strategy is scaled up. While this is not a problem when algorithmic trading strategies are first deployed with very small risk exposure, it becomes an issue over time as they are scaled up.

Profitability does not increase linearly as risk is increased. Instead, the rate of increase of profitability slows down as size is increased but risk continues to increase, and that is due to market impact reasons. Eventually, strategies reach a size where large increases in risk still only marginally increase profitability, which is where the strategy has reached the limit of what it can be scaled up to. This is, of course, if we account for market impact when analyzing expected risk versus reward. Here, inaccuracies will always end up causing the trading strategy to take a lot more risk for very little extra profit and might end up causing a seemingly profitable trading strategy to massively underperform when deployed and scaled up in live markets.