Slippage inevitably happens to every trader, whether they are trading stocks, forex (foreign exchange), or futures. It is what happens when you get a different price from what you expected on an entry or exit from a trade.
If the bid-ask spread in a stock is $49.36 by $49.37, and you place a market order to buy 500 shares, you may expect it to fill at $49.37. In the fraction of the second it takes for your order to reach the exchange, something might happen, or the price could change. The price you actually get could be $49.40. The $0.03 difference between your expected price of $49.37 and the $49.40 price you actually end up with is called "slippage."
- Slippage occurs when you make a trade, and the price is higher or lower than expected for buying and selling, respectively.
- Market orders leave traders susceptible to slippage, because they may allow a trade at a worse price than anticipated.
- Traders can use limit and stop-limit orders to prevent trades above or below a set price, and avoid slippage.
- Stop-loss orders can also be used to minimize slippage when a stock's price is moving unfavorably.
- It's also important to avoid trading during major news events, as they can be prime occasions for slippage.
Order Types and Slippage
Slippage occurs when a trader uses market orders. Market orders are one of the order types that are used to enter or exit positions. To help eliminate or reduce slippage, traders use limit orders instead of market orders.
A limit order only fills at the price you want, or better. Unlike a market order, it won't fill at a worse price. By using a limit order you avoid slippage. Two disadvantages of using a limit order are that it only works if the price reaches the limit you set, and if there is a supply of the stock available to buy at the time it reaches your price.
A limit order and stop-limit order (not to be confused with a stop-loss) are often used to enter a position. With those order types, if you can't get the price you want, then you simply don't make the trade. Sometimes, using a limit order will mean missing a lucrative opportunity, but it also means you avoid slippage.
Using a market order ensures that you execute your trade, but there is a possibility that you will end up with slippage and a worse price than you expected.
Ideally, you will plan your trades so that you can use limit or stop-limit orders to enter or exit positions, avoiding the cost of unnecessary slippage. Some strategies require market orders to get you into or out of a trade during fast-moving market conditions. Under such circumstances, be ready for some slippage.
If you are already in a trade with money on the line, you have less control than when you entered the trade. You may need to use market orders to get out of a position quickly. Limit orders may also be used to exit under more favorable conditions.
As an example, suppose a trader buys shares at $49.40 and places a limit order to sell those shares at $49.80. The limit order only sells the shares if someone is willing to give the trader $49.80. There is no possibility of slippage there. The seller will get $49.80 (or more, if there is a demand).
When setting a stop-loss (an order that will get you out when the price is moving unfavorably), you might use a market order. That would guarantee an exit from the losing trade but not necessarily at the desired price.
Using a stop-loss limit order will cause the order to fill at the price you want unless the price is moving against you. Your losses would continue to mount if you couldn't get out at the price specified. This is why it is better to use a stop-loss market order to ensure the loss doesn't get any bigger, even if it means facing some slippage.
When the Biggest Slippage Occurs
The biggest slippage usually occurs around major news events. As a day trader, avoid trading during major scheduled news events, such as FOMC announcements or during a company's earnings announcement. While the big moves seem alluring, getting in and out at the price you want may prove difficult.
If you're already in a position when the news is released, you could face substantial slippage on your stop-loss, exposing you to much more risk than expected. Check the economic calendar and earnings calendar to avoid trading several minutes before or after announcements that are marked as having high impact.
Manage Risk During Announcements
As a day trader, you don't need to have positions before those announcements. Taking a position afterward will be more beneficial as it reduces slippage. Even with this precaution, you may not be able to avoid slippage with surprise announcements, as they tend to result in large slippage.
If you don't trade during major news events, large slippage usually won't be an issue, so using a stop-loss is recommended. If catastrophe hits, and you experience slippage on your stop-loss, you'd likely be looking at a much larger loss without the stop-loss in place.
Managing risk does not mean that there will be no risk. It means you are reducing as much risk as you can. Don't let slippage deter you from managing your risk in every way possible.
Slippage Is Common Throughout Markets
Slippage also tends to occur in markets that are thinly traded. You should consider trading in stocks, futures, and forex pairs with ample volume to reduce the possibility of slippage.
You could also trade stocks and futures while the major U.S. markets are open (if trading in the U.S.). Another idea is to trade forex when London and/or the U.S. are open, as that tends to be the most liquid and active time for most currency pairs.
You can't totally avoid slippage. Think of it as a variable cost of conducting business. When possible, use limit orders to get into positions that will reduce your chances of higher slippage costs.
Use limit orders to exit most of your profitable trades. If you need to get into or out of a position immediately, you can use a market order. When placing a stop-loss, you can use a market order. Market orders are prone to slippage, but a small amount is acceptable if you need to execute your trade quickly.
Frequently Asked Questions (FAQs)
What is slippage tolerance?
Slippage tolerance is an order detail that effectively creates a limit or stop-limit order. This term is more common with crypto trading platforms. In markets offered by traditional brokerages, such as stocks, bonds, and options, you'll use a limit order rather than setting a slippage tolerance. With slippage tolerance, you set a percentage of the transaction value that you're willing to accept in slippage. For example, if a trader places an order with 2% slippage tolerance to buy $100 worth of bitcoin, then that order could actually cost as much as $102. If the transaction would cost more than $102, then the order wouldn't execute.
How much stock volume should you look for to prevent slippage?
This question ultimately comes down to personal preference. Most traders will find a volume threshold at which their strategy works most efficiently. To be sure you're reducing slippage risk, you may want to look for high-volume stocks that trade tens of millions of shares per day.