We continue the series of articles about the basic terms and definitions in trading. Understanding of the main mechanisms of the trading process is crucial for the profitable trading, and it helps beginners to avoid common mistakes as well as find answers to questions like ‘Why is this happening?’, ‘What is influencing the price action?’, ‘How do the quotes change work?’. All of the explanations are supported by real trading examples based on multi-years successful practice.
The slippage is the difference between the price at the moment of sending an order to the broker and the price which was actual at the moment when the order has been executed. Let’s imagine that you have sent an order to open a position with the current market price to buy some ‘guinea pigs’ when the quote was 4 dollars, while the brokerage confirmation was 4.25 dollars. Why is that? Then the price goes up to 6 dollars, and you send an order to sell by the market price, but you get only $5.75. How so? We are used to paying for something that is written on the price tag in our everyday life. But here, in ‘Guinea pigs’ fabric in its adult variation, they take a quarter from you while buying and another one while selling. And it happens that even more. These quarters can set a huge amount of money even with a moderately active trading. Who’s pocket are they heading to? The slippage is one of the main income sources for market professionals, and this is why they keep diligently silent about that topic.
Shares, futures contracts and options do not have a fixed price. They always have two prices which are changing rapidly at any given moment. The first price is the price of demand (bid), and the second one is the price of supply (ask). The demand price is the amount of money that you can get from selling an asset, while the supply price is equal to the sum which you have to pay for buying it. When a buyer is rushing, a professional trader will sell him immediately with the current supply price. An amateur is afraid to miss the train, and he pays more to a professional, who gives him an opportunity to own the shares immediately. Professionals offer the same service to shares holders. If you are afraid of the price decline and you want to sell as fast as possible, a professional will buy your goods right now, but with the demand price. Holders, scared of a price collapse, can through shares out with ridiculously low prices. The slippage value depends on the markets players’ nerve strain.
An exchange hall professional sells to buyers and buys from sellers, not because of the charity. He’s doing business, not philanthropy. He paid a high price at some point of time to get his place where buy- and sell-orders intersect, he purchased or rented the hall workplace installing an expensive hardware. The slippage is the payment that he takes for his fast service.
Some orders exclude the slippage, some ask for it. There are three most popular types of orders: market execution, limit-order and stop-order. The limit-order designates the price. For example, “Buy 100 shares of ‘Guinea pigs’ fabric at the price of 4 dollars each”. If the market is quiet and you are ready to wait, then you would have pretty good chances to get this price. If by a moment when your order appears in the market, ‘Guinea pigs’ shares price will fall below 4 dollars, you would be able to get some benefit of that, although do not count to have such a situation too often. If the market goes above the four-dollars mark, the limit-order to buy at the underlined price will not be executed. The limit-order allows you to control buy or sell price, but it does not guarantee the deal execution.
The market order allows you to buy or to sell immediately, whereas the deal execution is guaranteed, but not the price. If you want to buy or sell something right now, at this particular moment, do not hope for the best possible price. Once you get the execution guarantee, you lose the price level control, and in most cases, your order will become a victim of the slippage. Nervous newbies’ market orders allow professionals to make money not only for a piece of bread but also for a layer of butter on it.
The stop-orders turns into the market-order when the market approaches the given level of the price. Let’s imagine that you have bought 100 ‘Guinea pigs’ shares by $4.25 and you expect the price to grow up to $6, but at the same time, you want to protect your position with the stop-order at $3.75. If the price dropped to $3.75, your stop-order would turn into the market order and it would be executed by whatever market price at that particular moment. You will close the position, but you have to be ready for some slippage losses in fast-moving market conditions.
You should think what is more important for you when sending an order, whether it is the price or time. The limit-order allows you to control the price but it does not guarantee that the deal will happen. The market-order guarantees the execution, but it does not guarantee the price. Cold-blooded and patient traders prefer limit-orders, whereas market-orders amateurs get continuous losses on the slippage.
The vast majority of traders lose more money on the slippage rather than on commissions. The well-known trader Elder makes a great example of calculating both spending items in percentage relation to the trading capital in his book ‘How to speculate and win on the stock exchange’. He expressed a surprise that nobody paid attention to that information, while he thought that it should be the most mind-blowing part. When people are getting embraced with fear or greed, they go for a deal by any price without thinking about their long-term interests (and digging a hole in the efficient market theory).
Some of the companies that provide services for intraday trading, promise to teach traders how to take benefit of the slippage, trading inside the spread between bid and ask prices. Their method does not guarantee the success, while commissions that appear during the rapid trading eliminate any advantage. People invest a lot of money, signing up for level 2 quotes, but their results still suffer.
Getting into the market is like jumping into a fast river. As long as you walk along the shore, choosing the best place for the jump, you have got nothing to be afraid of, and you do not have to rush. But it would be much harder to get out of the flow. You can plan an exit point, a reference point to take the profit, and place the limit-order there. Or you can trust the river flow and swim in it, protecting your position with trailing stop-orders. In this case, you can make more profits, but the slippage grows as well.
It is better to use the limit-orders while opening a position. Some of them will not be executed, but it is not a problem, as the market river has been flowing more than a hundred years. A serious trader uses limit-orders for positions openings and he tries to use them for taking profits, protecting his open positions with stop-orders. Effort directed to lower the slippage reflect on your profitability immediately, increasing chances for the long-term success.