It could get worse. Those quarters and halves can add up to a small fortune for a moderately active trader. Who gets that money? Slippage is one of the key sources of income for market professionals, which is why they tend to be very hush-hush about it.
No stock, future, or option has a set price, but it does have two rapidly changing prices—a bid and an ask. A bid is what a buyer is offering to pay, whereas an ask is what a seller is asking. A professional is happy to accommodate an eager buyer, selling to him instantly, on the spot—at a price slightly higher than the latest trade in that market. A greedy trader who’s afraid that the bullish train is leaving the station overpays a pro who lets him have his stock right away. That pro offers a similar service to sellers. If you want to sell without waiting, afraid that prices may collapse, a professional will buy from you on the spot—at a price slightly lower than the latest trade in that market.
Anxious sellers accept ridiculously low prices. Slippage depends on the emotional state of market participants. The professional who sells to buyers and buys from sellers is not a social worker. He is running a business, not a charitable operation. Slippage is the price he charges for rapid action. He has paid a high price for his spot at the crossroads of buy and sell orders, buying or leasing an exchange seat or installing expensive equipment.
Some orders are slippage-proof, while others invite slippage. The three most popular types of orders are limit, market, and stop. A limit order specifies the price; that is, “Buy 100 shares of Guinea Pig Factory at $4.” If the market is quiet and you’re willing to wait, you’ll get that price. If GPF dips below $4 by the time your order hits the market, you may get it a little cheaper, but don’t count on it. If the market rises above $4, your limit order will not be filled. A limit order lets you control the price at which you buy or sell, but doesn’t guarantee you a fill.
A market order lets you buy or sell immediately, at whatever price you can get at the moment. The execution is guaranteed, but not the price. If you want to buy or sell right away, this very moment, you cannot expect to get the best price—you give up control and suffer slippage. Market orders placed by anxious traders are the bread and butter of the pros.
A stop order becomes a market order when the market touches that level. Suppose you buy 100 shares of Guinea Pig Factory at $4.25, expect it to rise to $7, but protect your position with a stop at $3.75. If the price slides to $3.75, your stop becomes a market order, executed as soon as possible. You’ll get out, but expect to suffer slippage in a fast-moving market.
You can choose what you want to control when you place an order—the price or the time. A limit order lets you control the price, with no assurance of a fill. When you place a market order, a fill is assured, but not the price. A calm and patient trader prefers to use limit orders, since those who use market orders keep losing slivers of capital in slippage.
Slippage tends to be a much bigger expense than commissions. I estimated the size of both in Trading for a Living and thought this was one of the most explosive parts of the book, but very few noticed. People in the grip of greed or fear want to trade at any price, rather than focus on their long-term financial interests. So much for the efficient market theory.
There are day-trading firms promising to teach traders to take advantage of slippage by trading inside the bid-ask spreads. Their technology does not guarantee success, while commissions from active trading negate any advantage. People pay a lot of money for Level 2 quotes, but I haven’t noticed any great increase in performance among those who use them.
Getting into a trade is like jumping into a fast-moving river. The opportunity as well as the danger is in the water. You are safe standing on the bank and can control where and when to jump, but getting out of the water can be more tricky. You may see a spot where you want to get out—a profit target, where you can place a limit order. You may want to let the river carry you as long as the current allows, protecting your position with a trailing stop. That may increase your profits, but it also will increase slippage.
Limit orders work best for entering trades. You’ll miss a trade once in a while, but there will be many others. That river has been flowing for hundreds of years. A serious trader uses limit orders to get in and to take profits, and protects his positions with stops. Anything we can do to reduce slippage goes directly to our bottom line and improves our odds of long-term success.
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