What is Slippage and Why is it Important?
Slippage is the difference between the expected price of a trade and its final execution price in financial markets. In this blog, we will outline the factors that influence slippage and how traders can minimise its impact on their profits.
In the world of finance, the term slippage denotes the difference between the expected price of a trade and the actual execution price of the trade. Traders venturing into fast-moving markets with high price volatility that leads to substantial deltas between the expected and the actual trade price would recognise slippage as a common phenomenon.
Positive and negative slippage
Slippage can either have a positive or a negative impact on a trade. A trade getting executed at a better price than expected experiences positive slippage. Similarly, a trade that executes at a price that is worse than expected experiences negative slippage. When small price differences lead to significant impacts on profits or losses, traders and investors often try to mitigate the impact of slippage. Strategies where precise execution is critical like algorithmic trading are particularly prone to this. Now, let us understand the factors that contribute to slippage.
Factors contributing to slippage
Several factors can contribute to slippage in the market, including:
- Market Volatility: Prices experience rapid changes in a highly volatile market. Due to this the execution price of trades are often different than the expected price.
- Liquidity: If a market lacks liquidity, it becomes difficult to find a counterparty that accepts the other side of the trade at the expected price. This often leads to slippage as trades get settled at less than favourable prices.
- Market Impact: At times, trades with substantial footprints or large trades can move the market. This means if a trader executes a large order, the act of purchase or selling can result in a different execution price than expected.
- Order Type: Order types also leave their impact on slippage. Limit orders are better at evading slippage by accepting a specified price or better. Market orders, on the other hand, are more prone to slippage as they are only executed at the best available price.
- Technology and Latency: In markets with high-frequency trading, a multitude of trades get executed in milliseconds. This high-speed trading system often leads to latency and delays in order processing leading to slippage.
Understanding with an example
Let us explore the concept of slippage with an example in the context of a market order. Suppose a trader wants to buy 100 shares of a stock for which the current bid price is INR 500 and the current ask price is INR 510.
If the trader places a market order to purchase the 100 shares with the expectation to get the best available price, that might not always be the case. By the time the order gets executed at the market, several changes may have taken place to the order book, particularly, due to shifting market dynamics. The possibilities include:
Expected order price:
Since the best available ask price is INR 510, the trader expects to buy the shares at:
Total cost = 100 shares x INR 510 = INR 51,000
Order price with Slippage:
Let’s say the market experiences volatility or some other factor that raises the actual execution price of the shares. If the actual execution price lands at INR 515 instead of 510, then the total cost would be:
100 shares x INR 515 = INR 51,500
Here, the slippage is INR 51,500-51,000 = INR 500. The trader has to bear this additional cost as there is a difference between the expected price and the execution price of the shares. This could have been beneficial for the trader if the market had moved in a different direction leading to positive slippage and a lower execution cost than expected. Slippage, thus, remains a common consideration for traders and they must manage trade executions carefully to minimise its impact on their trading performance.
Mitigating the impact of slippage
So, how can traders mitigate the impact of slippage? Thankfully, there are strategies and tools, which when implemented well can help traders execute trades with higher levels of efficiency. Let us explore a few common ones here.
- Using Limit Orders: Traders must consider using limit orders instead of market orders to control the price at which the order is executed. Limit orders allow them to specify the maximum payable price when purchasing or the minimum selling price when selling.
- Implementing Algorithmic Trading: Algorithmic trading strategies can create smaller manageable pieces from large orders and execute them over time. This approach reduces the total market impact of large trades and helps in mitigating slippage.
- Timing Trades: Traders should be always mindful of market conditions and the timing of their trades. Avoiding periods of high volatility, such as major news events or economic announcements when slippage is more likely, can help them overcome price differences and evade slippage.
Slippage is a common occurrence across most global markets and is frequently out of control for most traders. What they can instead do is adopt mitigating techniques and strategies to maximise the benefits of trading. Consulting a financial expert can also be of great help in avoiding slippage and its consequences.