Getting into investing and trading can be exciting. It can be rewarding. And if you’re like me, it can be an obsession. But I’m the first to admit that the terminology can get very confusing when you’re starting out. With that in mind, I would like to explain a term that you’re likely to come across sooner or later: slippage.
What is slippage?
Slippage refers to the difference between the market price you expect for an order and the actual market price that you end up getting when that order is fulfilled. Slippage can be either positive or negative but usually refers to negative price execution.
As you can see, the underlying meaning of slippage is quite simple. But to help you become a better investor, we have to go deeper than a simple definition. We’ll discuss what causes slippage, why it matters, and how to avoid it. We’ll also see that some methods of preventing slippage can have risks of their own.
When Does Slippage Occur?
While it’s impossible to avoid some forms of slippage completely, there are certain situations in which slippage is more likely to occur. These situations include:
- Using delayed quotes, or slow order entry methods increases slippage
- Trading in stocks or markets with higher volatility boosts your risk of slippage
- Entering larger orders will increase the amount of slippage you have
- Trading stocks with low volume leads to more slippage
- Trading after regular market hours can also lead to slippage
- Day traders need to worry about slippage more than long term investors
We’ll make sure to explain each of these situations below, and then discuss potential ways of avoiding slippage. Read to the end and you’ll know more about slippage than all your trading buddies!
(Notice I said trading buddies! This might not score any points at your next cocktail party!).
How Delays Increase Slippage
We’ll start with the easiest one. Since slippage is a difference between the price you expect your order to receive and the price it actually gets, it’s easy to see how delayed pricing data or slow order execution provides more time for the market to change before your order is filled. And not all trading platforms or order methods are created equal.
Back before the internet transformed investing, slippage due to delays was not a surprise. It was expected because significant delays were unavoidable. You used to look at a newspaper to get your prices, and then you would pick up the phone and call your broker to put in your order. They would write your order down, confirm it to you, then call or fax it to their trading department. The trading department probably had people in “The Pit” fulfilling orders. Not only were you getting delayed prices, but the whole order process could take 30 minutes or more.
Fast forward to today, when many aspects of the markets are automated using computer networks. This has made it easier to get a current price quote, and it has created many options for entering an order directly into a broker’s system online. This leaves less time for the market to change - in other words, less time for slippage.
While the internet has improved the delay factor, not all methods for submitting orders are equally efficient, so you should do some due diligence when deciding how and where you will send your orders.
How Volatility Increases Slippage
Trading a volatile security also increases risks of slippage. Volatility essentially means that the price of a security is experiencing more significant price changes. So higher volatility means that the price is more likely to fluctuate between when you submit an order and when that order is ultimately fulfilled - even if you’re using a system with relatively few delays.
How Order Size and Volume Affect Slippage
Order size and volume also play a role in slippage - they are two sides of the same coin. Imagine you are entering a small buy order. You glance at the bid/ask spread, you like the asking price, and click buy. Because you are only buying a few shares, you can reasonably expect that there are enough shares at the current ask price to fill your order. In that case, you will have received the execution price you expected. In other words, you will have avoided slippage. But if you enter a large market order, you are more likely to buy all available shares from multiple offers at ascending prices, which will drive your average price per share up from what the spread is currently showing you. Let’s look at a simplified hypothetical example to see how this works.
Example of Slippage Due to Order Size
Suppose you want to buy 5,000 shares of XYZ stock, which you think will rise soon. XYZ is currently trading at $24.50/$24.53. You decide you like $24.53 per share and enter your order promptly. What you don’t realize is that there is currently a low offer volume compared to your order size. Here are the relevant offers in the order book:
|Shares Offered||Ask Price|
Your large order takes the first 4 offers completely and is filled by taking 950 shares of the 5th offer at $24.65. You expected to pay $24.53 per share, plus commissions, but your order confirmation comes back showing that you ended up paying more like $24.59 per share. This slippage was the result of your order size compared to the volume of offers.
This example can help us understand another term: Market Impact. Your order had market impact because it was large enough to change the price of what you were buying (moving the spread from $24.50/$24.53 to $24.50/$24.65).
Why Trading After Hours Increases Risk of Slippage
This situation is directly related to the earlier point about how volume (and liquidity) effect slippage. Stocks and ETFs are traded after hours quite easily, but fewer people are trading during those times than during regular market hours. This means that you are more likely to experience the effect we saw in the example above due to the lower volume of orders that can match your request. We’ll see one solution for this below when we talk about order types.
Why Day Traders Need to Consider Slippage More
While there are many different types of traders, day traders and scalpers need to consider slippage to a much greater extent than someone who is going long with a stock or ETF because they are making more frequent trades (so the effects of slippage can compound quickly to eat into profits). They are often trying to profit on much smaller price changes (so a few cents of slippage takes a more substantial chunk of their profit margin). An investor with a longer time horizon is going to make fewer trades and wait for more significant price changes. So a few cents per share of slippage has a much smaller impact on their profit margin.
How to Minimize Slippage
Now that we’ve seen the causes of slippage from multiple angles, it should be much easier to see the solutions. Defining a problem accurately is often the most critical step to solving it.
Slippage Solution #1: Reduce Delays and Avoid Volatility
First, don’t submit market orders by calling your broker. Not only is it usually more expensive to fulfill an order via phone call, but it typically takes longer for your order to get filled. Instead, take advantage of online trading platforms that generally allow you to reduce the time delay from minutes to seconds (or even milliseconds). In addition, you can reduce slippage by avoiding volatile stocks and markets altogether. You can also limit your trading activity during planned news events such as company earnings reports or government market reports. For many investors, this isn’t a bad idea, but assuming you do want to trade a volatile holding, the next solution will be helpful.
Slippage Solution #2: Use Limit Orders (Carefully)
Second, consider using limit orders instead of market orders. A limit order allows you to set a specific price as a condition on the order’s fulfillment. If your pricing condition isn’t met, then the order doesn’t get processed. This is one way to manage slippage even in volatile conditions.
The only problem with this solution, and it can be significant in certain situations, is that you run the risk of your trigger price never getting hit - and your order never being filled at all. In certain circumstances where the price is trending up or down, you could get stuck having to enter your order at a much worse price later on. In that case, you would have been better off using a market order, accepting some slippage, and being sure your order would be filled. There is debate in the investing community about how effective limit orders are in dealing with volatile securities as well. You’re probably best not trying to game volatility with limit orders.
Slippage Solution #3: Avoid Shallow Securities
You can reduce slippage due to order size by avoiding securities with low daily volume. The more people there are actively trading a security, the less you have to worry about your order size.
Slippage Solution #4: Trade the Open Market with Longer Plays
This one doesn’t need much explaining if you read the section above on trading after hours and day trading. If you trade during the day, you’ll be trading a deeper market, and if you focus on more extended strategies with fewer trades and larger margins, you’ll reduce the effects of slippage as a percentage of profits.
We have now defined slippage and considered its various causes, as well as how to minimize it. We’ve also seen that there are trade-offs to consider when avoiding slippage. Seasoned investors recognize that some slippage is just a fact of life, and they manage it only if that serves their ultimate purpose.
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