Slippage

Slippage is an important concept in stock trading that can affect how much money you make or lose.

What is Slippage?

In its simplest form, slippage happens when the price you expect to pay (or receive) for a stock is different from the actual price you pay (or receive) when the trade is completed. Imagine you want to buy a video game that you see listed for $20, but by the time you get to the store, the price has changed to $25. That difference in price is similar to what slippage is in stock trading.

Why Does Slippage Occur?

Slippage can happen because of changes in demand and supply in the market. Stock prices change constantly due to different traders buying and selling shares. When you place an order to buy or sell a stock, it takes a moment for that order to be processed. During that time, the price may go up or down, causing slippage.

Examples of Slippage

• Positive Slippage: If you place an order to buy a stock at $100 but it executes at $99, you've experienced positive slippage, meaning you got a better price than expected.
• Negative Slippage: If you place an order to buy a stock at $100 but it executes at $101, you've experienced negative slippage, which means you paid more than expected.

Slippage and Types of Orders

Different types of orders can influence how much slippage affects your trade. The two most common order types are:

• Market Order: A market order means you want to buy or sell the stock immediately at the current market price. However, market prices change quickly, so slippage can happen with this order type.
• Limit Order: A limit order allows you to set a specific price at which you want to buy or sell. This can help you avoid slippage because the order will only execute at your set price or better. However, if the stock price doesn't reach your limit, the order may not execute at all.

Factors That Affect Slippage

Slippage doesn't happen all the time, and there are specific conditions that can make it more likely:

• Market Volatility: When the market is very active or volatile, prices change rapidly. This usually happens around the opening and closing of the market, during major news events, or in times of economic uncertainty. Increased volatility can lead to more slippage.
• Liquidity: Liquidity refers to how easily you can buy or sell a stock without affecting its price. Stocks with low liquidity, such as small-cap or penny stocks, tend to have higher slippage because there aren't enough buyers or sellers at a specific price point.
• Order Size: Large orders can also lead to more slippage. When you place a big order, it may fill across multiple price points if there aren't enough shares available at your desired price. This is more common in less-liquid stocks.

How Traders Try to Avoid Slippage

Traders often use strategies to minimize slippage and ensure that they buy or sell stocks at their intended price. Here are some methods:

1. Using Limit Orders: As mentioned, limit orders allow traders to set a specific price, which can protect against unexpected price changes.
2. Avoiding Trading During High Volatility: Some traders avoid placing trades right when the market opens or closes since those times are more volatile.
3. Trading High-Liquidity Stocks: By focusing on stocks that have high liquidity, traders may experience less slippage.

The Impact of Slippage on Profits and Losses

For professional traders, especially those who make frequent trades, slippage can have a significant impact on profits and losses. Here are some considerations for advanced traders:

• Risk Management: Slippage is considered part of “market risk,” and traders calculate it as part of their overall risk management strategy.
• Trading Algorithms: Some high-frequency traders use complex algorithms to minimize slippage. These algorithms can automatically buy or sell based on pre-set criteria to avoid high-slippage conditions.
• Execution Costs: Slippage is a hidden cost that impacts a trader's total execution costs. Professional traders often calculate this to understand the “effective” price they're paying for stocks.

Slippage in Different Trading Strategies

Different trading strategies are more or less sensitive to slippage. Here are a few examples:

• Scalping: Scalpers make many trades per day for small profits on each trade. Slippage can significantly reduce their profitability because small price differences add up.
• Day Trading: Similar to scalping, day trading also involves many trades within a single day. While slippage is a concern, day traders may use limit orders to mitigate it.
• Long-Term Investing: For investors holding stocks for years, a small amount of slippage on a single trade is less impactful. Over time, small price differences may be offset by the stock's growth.

Conclusion

Slippage is an essential concept in stock trading that affects the final price at which trades are executed. For beginners, it's helpful to understand slippage to better manage expectations when entering or exiting trades. Advanced traders incorporate slippage into their risk management strategies, using limit orders, avoiding high volatility, and trading high-liquidity stocks. By recognizing the impact of slippage on profitability and developing strategies to reduce it, traders can improve their trading outcomes.