Do you know how to avoid slippage? Before we get to that, we want to make sure you what is slippage in trading. It's important!
There is a lot of things you want to avoid in the market, and this is one that you want to avoid at all costs. And one that inevitably occurs to all traders, who learn the hard way: Slippage.
And no, I'm not referring to what happens when you wear heels on ice. Slippage is a common phenomenon in the stock market. Indeed, its one you want to avoid like the plague or it will eat away at your profits...or compound your losses.
Today I'm going to show you how to avoid slippage before you see for yourself if your feet can go over your head.
How to Avoid Slippage
Humor me for a minute as we use your car for an example. Imagine you pull your car up to the pump to get gas and notice the price is $4.93 a gallon.
After letting out a long sigh, you decide to fill your tank up because you're not going anywhere without gas.
However, in the time it takes for you to pump the gas and walk inside to pay, something may change, or, the quote is delayed.
Shockingly when you go inside to pay, you're charged $4.96, $0.03 more than your expected price of $4.93 - what the heck?!!
In the financial world, we call this difference in the bid/ask (pump price/cashier price) spread, slippage. Or, the difference between a trade's expected price and the actual price of execution.
Why Does Slippage Occur?
Sometimes I wish I had a crystal ball that could tell me why or what is going to happen. Now that I think of it, it would come in quite handy in the stock market trading.
As it stands now, I have no crystal ball. But, what I do have is evidence from the past. We see slippage occurring when market orders get placed during times of high volatility in the market.
We also experience slippage when large orders get placed without enough buyers at the table interested in buying the asset.
Make sure to take our free online trading courses to learn how to safely trade to stock market and learn how to avoid slippage.
What Is Slippage and Market Orders
Slippage occurs when a trader uses market orders.
To refresh your memory, if you're placing a market order, you are telling your broker to immediately buy or sell the stock for you at any price. Yes, at any price.
Aside from being hasty, if you place a market order, you have no control over the fill price. You get filled on the wrong side of the bid-ask spread. Essentially, a market order buys at the ask (high side) and sells at the bid (low side).
In the trading arena, for example, if the bid-ask spread is $12.00-$12.02, market orders should buy immediately at $12.00 for you. Right? Wrong.
By the time your market order arrived at the Exchange, the stock had soared on news to $12.15. Unfortunately for you, your buy market order gets filled at $12.15 - a 15 cents slippage. And that is bad, really, bad.
The solution? Use limit orders instead of market orders.
Unlike a market order, a limit order only fills at the price you want, or better. The keyword here is limit; a limit order limits the price you are willing to pay for the stock.
You tell your broker to buy or sell a specific stock at or better than a set price specified by you. The important thing is: you avoid slippage. You are in control of your trades, and this should be your ultimate goal.
How to Avoid Slippage When Entering Positions
We have a few different order types ranging from limit orders to stop-limit orders to enter a position. Please remember not to confuse stop-limit orders with a stop loss; they are different.
I encourage you to review our blog posts on the different types of orders to refresh your memory.
When entering a position, use a limit or stop-limit order to avoid slippage. The only downside here is that you may miss a good move.
So if you can't get the price you want, then you don't trade; it's better to be safe than sorry; especially when learning how to avoid slippage.
Here is a nugget of wisdom I have gleaned from my time trading that I thought I should share with you: Stop worrying only about how you enter a trade. The key is to know at all times when you will exit.
There are a few ways to exit a position, all of which depend on the situation at hand. Firstly, if you're in a trade and for whatever reason, need to get out quickly, you may need to use a market order.
Again, this will guarantee an exit from your losing trade but not necessarily at the price you want.
However, if you're in a trade that is going your way, it makes sense to place a limit order at your target price. Assume you buy shares of $FB at $150.50 and set a limit order to sell at $150.90.
Your limit order only sells your shares if someone is willing to give you $150.90 for them. In this scenario, there is no possibility of slippage, and you get $150.90 (or more).
Using a stop-loss limit order will only fill at the price you want. Which means when the price is moving against you, your loss will continue to rise if you can't get out at the price you specified.
In light of this, 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 incurring some slippage.
When to Expect the Most Slippage
Just like the predictability of the sun rising and setting every day, the impact of significant news events on the market is just as predictable.
I'm sure you can recall a time in which the market responded to major news (i.e. trade wars), such as SEC investigations or a company that failed to make earnings.
Or better yet, a company whose share price tanked over a simple tweet. We all know that earnings times, in particular, are times of volatility. Although the significant price moves may be alluring, they can be dangerous as well.
Once in a trade, you might find getting out difficult and experience slippage on your stop loss. The end result: your account is exposed to more risk than it should.
To avoid this, ensure you check both the economic and earnings calendar and steer clear of trading before these announcements.
If acting on news, stock tips and financial reports were the real keys to trading success, then everyone would be rich. You must keep in mind that profits in day trading aren't made from trading the news.
Another scenario we will inevitably run into is the surprise news announcements. They are rare, but when they do occur the slippage might be substantial. So to prevent this, have a stop loss in place; otherwise, you'll be staring down the barrel of a massive loss.
We also see slippage in markets that trade thinly with low volume, and large bid-ask spreads. To prevent this ensure sufficient volume and float; my personal preference is a minimum volume of 300,000 with a tight bid/ask spread.
How To Prevent Slippage
I will give you some key points to manage your risk and help prevent slippage:
- Use limit orders to get into positions and use them when getting out of most of your profitable trades.
- If you need out immediately, meaning pure speed, use a market order. Or consider a "sell the bid" type order that immediately targets the current bidder.
- When placing a stop loss, use a market order.
- Avoid trading for several minutes around major news announcements. Wait for price to stabilize or a trend, or pattern to appear/
How to Avoid Slippage Final Thoughts
You can't wholly avoid slippage; think of it as a cost, like commissions. Sometimes it's a cost worth paying, but not all the time.
Stock traders can avoid slippage during volatile market conditions by not placing market orders unless they are completely necessary. The surest way to prevent slippage is to apply a guaranteed stop (limit) order.
Note that this is not the stop-loss order, but a guaranteed limit order that will always complete trades at the price at which you have set them.
I know all this information can seem and feel overwhelming, but we can all learn to trade for a living if we want to. So if you're serious and ready to start your trading journey, let us help you. We make it simple and easy to understand, no slipping required!