Understanding Slippage in Algo Trading

5 min read

Trading is never an easy job for anyone. No matter how well you prepare yourself, there will always be unexpected roadblocks. In trading, price movements are front and center to all investor activity. Rises and falls in prices are inherently part and parcel of the fluctuating markets.

The market sometimes comes with an unexpected bonus and sometimes with unwelcome surprises (depending on which way it goes), which is termed as slippage. Whether you are trading stocks, Forex, or futures, slippage inevitably happens. 

What is Slippage?

Slippage occurs when the execution price of a trade is different from its requested price. 

Any variation between the executed price and the intended price is considered as slippage. The slippage may be zero, positive, or negative, and also depends on whether the order is a buy or sell, or whether the order is for opening or closing a position, and even the direction of price movement. 

Slippage normally happens during high periods of volatility because orders cannot be matched at desired prices due to the fast pace of price movements in the financial markets at such periods. Hence, there is a higher chance of slippage may occur due to the delay that exists between the point of placing an order and the time it is completed.

How Slippage Occurs?

Anytime a buy or sell order is placed, the order is executed at the best available price offered on an exchange or by a market maker, which can produce results that are equal to, more favourable, or less favourable than the intended execution price. Thus, considering the actual execution price vs. the intended execution price, the order execution can be categorized as no slippage, positive slippage, or negative slippage.

As market prices can change quickly, slippage can occur during the delay between when a trade is ordered and when it is executed. Slippages occur with market orders or pending orders, such as stop orders (including stop loss orders), which are executed as market orders when the price reaches the set level.

A limit order prevents negative slippage, but it carries the inherent risk of the trade not being executed if the price does not return to the limit level. This is more likely to happen in situations where market fluctuations occur more quickly, which limits the amount of time for a trade to be completed at the intended execution price.

Examples of slippage:

No slippage: Let’s say you want to buy XYZ stock, and the bid/ask prices are quoted as Rs.50.50/Rs.50.54 on the broker’s platform. You place a market buy order for 200 shares, and the order gets filled at Rs.50.54, which is the ask price you intended to buy at. So, there is no slippage in this case.

Negative slippage: Let’s assume that the XYZ stock, which was quoted as Rs.50.50/Rs.50.54 on the broker’s platform, was filled for your buy market order at Rs.50.95. In this case, the buy order was filled at a worse price than intended. So, there was a negative slippage of Rs.0.41.

Positive slippage: In this case, you place your buy market order, expecting it to fill at Rs.50.54 as was quoted on the broker’s platform (Rs.50.50/Rs.50.54), but the order was filled at a lower price, say Rs.50.41. So, you have a positive slippage of Rs.0.13. Interestingly, if the price came up again to around the price quote you saw earlier, you are invariably in profit early on.

Why Slippage Occurs?

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
  • Slippage affects day traders more than the long term investors
  • Slow internet or outdated devices also increase the chances of slippage

1. Delays Increase Slippage:

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. 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. But still in today’s fast moving era if you are using an outdated device, or a slow internet facility or a device which is employed in multiple tasks simultaneously the chances of slippage increases.

2. 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.

3. Order Size and Volume Affect Slippage:

Order size and volume also play a role in slippage. Imagine you are entering a small buy order. You glance at the bid/ask spread, the ask price, suits you, click buy. For example, 400 shares of XYZ stocks are available and you wish to buy only 350 shares. 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 avoided slippage. 

But if you enter a large market order, for example, 200 shares of XYZ stocks are available at Rs.100/ share, 200 shares for Rs.500/share and 200 shares are available at Rs. 1000/share. Now 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. In that case you experience slippage.

4.  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. They are often trying to profit on much smaller price changes, so even a few cents of slippage takes a more substantial chunk of 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.

1. Reduce Delays 

Don’t just 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 1/10th of milliseconds. Along with a high internet and dedicated device for trading.

2. Avoid Volatility

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.

3.  Use Limit Orders

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.

Broker-Side Remedies

Perhaps the greatest challenge regarding slippage is that many of its drivers are not within a trader’s control. 

1. Automation: 

One way to greatly reduce latency and slippage is to automate your trading strategies. Automation incorporates trade selection, order placement, and trade management into one automatic function. In addition, automated strategies are often utilized via broker-furnished co-located servers, further increasing precision( check out our previous blog for understanding co-location in detail).

2. Robust trading software: 

Advanced order types, bracket orders, and low latency charting software are strong ways to improve trade-related efficiency. Having a broker that supports the ideal platform for the execution of your advanced trading strategies is a must.

Takeaway:

Slippage is manageable by using adequate technology and a competent broker. With adequate technology one can dramatically reduce poor trade execution. Sign in or sign up today with ShareIndia, and navigate financial markets more confidently.

Disclaimer: Any Advice or information in the post is a general advice for education purpose only and is not responsible for generating any trading strategy for anyone, please do not trade or invest based solely on this information.

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