Understanding Slippage in Trading

Slippage refers to the difference between the expected price of a trade and the actual price at which the trade is executed. For example, you press buy when the price of a security is at $50, but your order is filled at $50.12. The opposite could be true on the sell side, where you expect to sell at $50, but the order is filled at $49.83.

Slippage can occur in all types of trading, including stocks, forex, futures and options trades. This is a must know term because it can impact your trading results and implementation of a trading strategy overall.

What Causes Slippage?

Slippage typically occurs during periods of high volatility or low liquidity. High volatility means that prices are changing rapidly, often due to significant market news or events. Think things like the Fed announcement, earnings announcement, approval in biotechs, etc… When prices are moving quickly, it can be challenging to execute trades at the desired price. By the time you click buy, the price has already moved.

Low liquidity, on the other hand, means that there are not enough buyers or sellers in the market to fulfill orders at the expected price. This can happen with less popular stocks or during after-hours trading. Under these conditions, looking at the bid-ask spread will help you understand the minimum amount of slippage that is likely to occur.

Types of Slippage

There are two main types of slippage: positive slippage and negative slippage. Positive slippage occurs when the actual price at which a trade is executed is better than the expected price. For example, if you expect to buy a stock at $50 but the order is filled at $49.95, you benefit from positive slippage. Negative slippage, however, happens when the actual price is worse than the expected price. For instance, if you expect to buy at $50 but end up buying at $50.05, you experience negative slippage.

How to Minimize Slippage

While slippage cannot be entirely avoided, there are several strategies you can use to minimize its impact:

Use Limit Orders 

A limit order allows you to specify the maximum or minimum price at which you are willing to buy or sell a stock. Unlike market orders, which are executed at the best available price, limit orders are only executed at the specified price or better.

Trade During High Liquidity Periods

Trading during times when the market has high liquidity can reduce the chances of slippage. This is usually when the market is most active, such as during the opening and closing hours of the trading day. Pajama traders trading the overnight session often have to account for low liquidity and increased slippage.

Avoid Trading Around Major News Events

Significant news events can cause high volatility, leading to aggressive price movement and increased slippage. An easy solution to avoiding slippage is to just avoid trading during these periods entirely. Giving the market 15 minutes to settle out after a major event is a way to decrease risk.

Impact of Slippage on Trading

Slippage can blunt your trading results, especially for those who are highly active or using strategies that require precise entry and exit points. Even small amounts of slippage can add up over time, reducing your profits or increasing losses.

When backtesting or even forward testing a strategy on paper trading platforms you should build in extra padding to account for slippage. Oftentimes these simulation platforms are very generous when it comes to giving you fills. When you are actually routing orders to the exchange in a real account, there are no generous fills. Your order will be executed at the best price available, or at the limit order that you set.

Real-World Example

To illustrate how slippage works, consider a trader who places a market order to buy 100 shares of a stock expected to trade at $20 per share. Due to high volatility, the order is filled at $20.10 per share instead. The trader experiences negative slippage, paying an extra $0.10 per share, which amounts to an additional $10 for the 100 shares. This reduces the traders potential for profit by $10 instantly. Over time this adds up.

Conversely, if the trader places a limit order to buy the same 100 shares at $20 per share and the order is filled at $19.90 per share due to favorable market conditions, the trader experiences positive slippage, saving $0.10 per share, or $10 for the 100 shares. This is possible, but happens far less frequently than the first example. In this case, the trader has $10 of additional profit instantly compared to the intended entry.

Conclusion

Slippage is an unavoidable aspect of trading, but understanding its causes and effects can at least help you minimize its impact. By using strategies like limit orders, trading during high liquidity periods, and avoiding major news events, you can reduce the likelihood of experiencing significant slippage that eats into your profits.