Reducing Order Slippage While Trading
Slippage inevitably happens to every trader, whether they are trading stocks, forex (foreign exchange), or futures. Slippage is what happens 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 the second it takes for your order to reach the exchange, something might happen or the price could change. 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 with is called 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 (a position is your buy/sell price and stance on an asset). 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. The downfall of a limit order is that it only works if the stock reaches the limit you set, and if there is a supply of the stock at the time it reaches your price.
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 when in fast-moving market conditions. Under such circumstances, be ready for or account 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. This means 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, 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, if there is a demand).
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 cause the order to fill at the price you want unless the price is moving against you. This would mean your losses 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 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 to be problematic.
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 high impact.
Manage Risk During Announcements
As a day trader, you don't need to have positions before these announcements. Taking a position afterward will be more beneficial as it reduces slippage. Even with this precaution, you may not be unable to avoid slippage with surprise announcements as they tend to result in large slippage.
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 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 there will be no risk. It means you are reducing as much as 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 in stocks and futures while the major US markets are open (if trading in the US). Another idea is to trade on 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 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 in or out of a position immediately, use a market order. When placing a stop-loss, use a market order. Market orders are prone to slippage, but a small amount of slippage is acceptable if you need to get in or out quickly.