Reducing Order Slippage While Trading
Slippage inevitably occurs to every trader, whether they are trading stocks, forex, or futures. Slippage is when you get a different price than 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 a second, it takes for your order to reach the exchange something may change, or your quotes could be slightly delayed. The price you actually get maybe $49.40. The $0.03 difference between your expected price of $49.37 and the $49.40 price you actually end up buying at is called slippage.
Order Types and Slippage
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. That's great in some cases but not others, as discussed below.
Limit orders and stop limit orders (not to be confused with a stop loss) are often used to enter a position. With these order types, if you can't get the price you want then you simply don't trade. Sometimes using a limit order will mean missing a lucrative opportunity, but it also means you avoid slippage when getting into a trade.
A market order assures you get into the trade, but there is a possibility you will end up with slippage and a worse price than expected.
Ideally, plan your trades so that you can use limit or stop limit orders to enter positions, avoiding the cost of unnecessary slippage. Some strategies require market orders to get you into a trade in fast moving market conditions. Under such circumstances account for some slippage.
If we are already in a trade, with money on the line, we have less control than we did before we entered the trade. This means we may need to use market orders to get out of a position quickly. Limit orders may also be used in more favorable conditions.
When a trade is moving favorably, place a limit order at the target price. Assume 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 here. The seller gets $49.80 (or above).
When setting a stop loss—an order that will get you out when the price is moving unfavorably—use a market order. This will guarantee an exit from the losing trade, but not necessarily at the price desired. Using a stop loss limit order will only fill at the price you want, but when the price is moving against you this means your loss will continue to mount if you can't get out at the price specified. This is why it is better to use a stop loss market order to make sure the loss doesn't get any bigger than it already is, 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 having trades 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 problematic. If already in a position when 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 and avoid trading several minutes before or after announcements that are marked as high impact. As a day trader, you don't need to have positions before these announcements, take positions after.
Unfortunately, surprise announcements occur that may result in large slippage. This is unavoidable in some cases. If you don't trade during major news events, most of the time large slippage won't be an issue, so using a stop loss is recommended. If catastrophe hits and you get slippage on your stop loss, you'd be staring down a large loss even if you didn't have a stop loss in place. Don't let slippage deter you from managing your risk in every way you can.
Slippage also tends to occur in markets that are thinly traded. Trade stocks, futures, and forex pairs with ample volume. This will reduce the possibility of slippage. Also, trade stocks and futures while the major US markets are open (if trading in the US). Trade forex when London and/or the US are open, as this tends to be the most liquid and active time for most currency pairs.
You can't totally avoid slippage. Think of it as a cost, like the spread or commissions. It is a cost worth paying sometimes, but not all the time. When possible, use limit orders to get into positions. Use limit orders to get out of most of your profitable trades. If you need in or out of a position immediately, use a market order. When placing a stop loss, use a market order. Market orders are prone slippage, but a small amount of slippage is worth it if we need to get in or out quickly.