Slippage is a common occurrence when executing trades. It happens when there is a difference in price between when the order is placed and when it gets executed. Slippage can lead to a significant difference in these prices. We should monitor it to understand how these spreads affect the profitability of a trade succeeding. This article will help show you how.
As mentioned earlier, slippage is the difference between the price at which a trade is expected to get executed and the actual price at which it occurs. Slippage can be classified as positive slippage or negative slippage, depending on whether the difference is favorable or not. In a buy order for a stock, positive slippage occurs when the ask rate drops and you purchase it at a lower rate. Similarly, had the ask rate had increased, it would have been a case of negative slippage. While placing a market order, the slippage can be both positive or negative. However, in the case of limit orders, you can prevent negative slippage by locking in a price so that the trade executes at this price or a more favorable one.
Why Does Slippage Happen?
We mainly attribute slippage to two reasons: low liquidity and high volatility.
In a market with low liquidity, the time taken to execute a trade could be long enough to alter the price of the underlying asset. The unavailability of options to square off the position can cause a deviation in the price leading to slippage. A trader should be aware of the liquidity available in the market and place an order accordingly. It is always advisable to place a limit order so that the slippage is within an expected margin.
Another cause for this price change could also be an increase in volatility. During a period of high volatility, traders must be cautious of negative slippage, leading to a significant loss for the trader. Contrary to a negative slippage, traders can also reap the benefits when volatility is high during positive slippage and the price moves in the direction that makes it more profitable.
When does It Happen?
Below you’ll find some of the instances of when slippage happens:
The order volume is high: Sometimes, it can be difficult to execute a trade at a specific price. In these instances, orders may execute at multiple price points.
Illiquid asset: When a trader wants to place an order for an illiquid asset, it may not be available at the quoted price. You may have to pay a premium to purchase or sell.
Major announcements: A news affecting the price of an underlying can tend to cause prices to fluctuate. This may increase the slippage in a trade. This is essential for traders to consider. It includes news events like earnings updates that tend to increase the volatility of a trade.
The urgency to exit a position: Sometimes, a trader could be in a situation that prompts him to exit a position with a high level of urgency. In such a case, the trade’s slippage could be significant since the trader is willing to accept the high price differential.
When Are You At The Most Risk?
Slippage can be disastrous in certain cases. Consider a trader who has sold a call option on an illiquid asset and has not covered his position. When the price increases above the exercise price, there is a negative payoff for the trader. If the trader expects the price to rise further, he can offset the short call position by purchasing the asset or buying a call on the same underlying. The offsetting position could be difficult if the price continues to rise, and a trader could have exposure to high slippage given the illiquid nature of the underlying.
Another instance when the risk level is high is when the volatility is extremely high, and the trader needs to offload the position immediately. We can observe these scenarios during intraday trades. If a trader takes a long position and the price starts to drop rapidly following a piece of negative news, then the trader will presumably suffer negative slippage when they execute the trade in an attempt to minimize the loss for an intraday position. The situation could get more complicated if the price hits a lower circuit.
Good Examples of Slippage
The first example involves a market order to buy 100 shares of Microsoft when the ask price quoted is $230. Since Microsoft is a liquid stock, we expect price movements to be somewhat stable. By extension, this means we assume the order will execute immediately. If the new price quoted is $230.50, then the total cost of buying 100 shares would be $23,050. Had the order been executed at the original price, the cost incurred would have been $23,000. In this case, the slippage amounts to $0.50 per share or $50 for the 100 shares bought.
Next, consider an investor with an open position of 100,000 Mexican pesos. They want to convert it to US dollars when the ask rate is 20 MEX/USD. Mexican pesos are fairly illiquid by nature. The trader may have to execute the trade at an ask rate of 20.50 MEX/USD. Instead of receiving $5,000 (100,000/20), the trader has to settle for $4,878 (100,000/20.50). The slippage, in this case, turns out to be $122 approximately.
Positive and Negative Slippage
The examples in the section above were cases of negative slippage. As in, the movement in price led to a loss to the trader. This may not be the case every time, and slippage can also be positive for a trader. Suppose in the first example, the ask for Microsoft shares had actually dropped to $229.50. In such a scenario, the trader would have benefitted from a positive slippage worth $50. Likewise, in the example involving Mexican Pesos, a foreign exchange rate of 19.50 MXN/USD would be worth $128 in terms of positive slippage.
Slippage in the Futures Market
Much like other markets, buyers and sellers make bids in futures trading until they arrive at a common price. The process of price discovery may not match exactly for these two parties giving rise to slippage. The exchange acts as an intermediary, trying to match the best price available for the parties concerned. However, it may so happen that the executed price for the futures contract may not be beneficial to one of the counterparties.
Small margins can play a significant role in a futures transaction. That’s because your risk exposure for such contracts is exponentially higher than if you had invested in the spot market. For the same investment, the profit or loss is greater for a futures contract. That’s one reason why monitoring the execution price is imperative. In these cases, even a small amount of negative slippage could erase your profits. This makes it critical to monitor such leakages, especially for derivatives contracts. Slippage could also be a major bottleneck in trading strategies like scalping that rely on small tick movements.
How to Avoid or Reduce Slippage
Even as trading platforms evolve with state-of-the-art technology, it is virtually impossible to eliminate the inefficiencies that lead to slippage. While it may not be eliminated completely, there are ways in which slippage can be reduced:
Placing limit orders: A limit order can be an effective way compared to a market order, but the possibility of an order not getting executed cannot be ruled out in the former.
Don’t place trades during periods of high volatility: It has been observed that slippage tends to peak when the volatility is high. The announcement on new rates during FOMC or earnings miss for a stock could cause swings in the price that could be detrimental for a trade. If you as a trader don’t account for and keep track of such events, you could easily fall victim to high slippage.
Reduce exposure to illiquid assets: This ensures that the execution price is not compromised while settling a trade. This is imperative to consider, given the high deviation in the prices we see for illiquid assets that do not have a very active market.
Select a broker that offers stop-loss orders: Some brokers keep track of the prices that their users expect trades to settle at. If the available price results in high slippage, then these trades will not execute
While slippage is a simplistic concept in trading, the ability to influence profitability should not be ignored. There are several ways for a trader to reduce the impact of slippage. Whether you’re trying to maximize profits or minimize losses, you should not overlook these methods while placing an order. Trading systems have become increasingly sophisticated, so they can easily detect these small errors in price. This gives trading algorithms some advantage at finding these profitable opportunities. In such an advanced and reactive trading ecosystem, keeping track of slippage should also be a key task performed by a trader.
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