Slippage is the cost incurred when an options trader executes a trade at a certain price but pays more or receives less due to market fluctuations. This can happen in any trading scenario, whether buying or selling options.
While slippage may seem like just another unavoidable cost of trading, you can take steps to minimize its impact on your portfolio. This includes using limit orders to enter trades at a specified price or using stop losses and trailing stops to protect against significant market moves.
If you are looking to minimize slippage and improve your trading results, it's crucial to understand how the cost of slippage can impact your bottom line.
What is slippage?
Slippage occurs when an order is filled at a different price than the one originally specified by the investor. This can happen for several reasons, including market volatility and rapid price movements that result in orders filling at significantly different prices than those originally requested.
What is the actual cost of slippage?
If your trades are consistently filled at undesirable prices, it can significantly impact your overall trading results. That's why it's essential to understand your slippage tolerance - that is, the maximum amount of slippage you're willing to accept on a trade - to help minimize its impact on your trading results.
The recommended slippage tolerance varies by trader, but some general guidelines include:
- your average trade's slippage
- slippage that occurs during a period of high market volatility, when slippage is likely to be higher
- slippage that occurs during a period of low market volatility, when slippage is likely to be lower
For example, slippage may be as low as 0.01% during low market volatility, while slippage may be 0.50% or more during high market volatility.
How can you reduce slippage?
Traders can use multiple strategies to help reduce slippage and limit its impact on their overall trading performance.
Wide bid-ask spreads are a common cause of slippage. When bid-ask spreads are wide, you risk sub-optimal fills. High volume securities typically have narrower spreads, so it’s essential to trade highly liquid assets to avoid slippage.
You should also pay careful attention to execution speed and accuracy when placing orders. Faster execution speeds translate into smaller amounts of slippage, so it's essential to choose a reputable broker with fast and accurate trade executions.
Slippage can often be reduced by using limit orders rather than market orders. A market order fills an order at the best available price for the asset at that moment, whereas a limit order specifies that an order must be filled at a certain price or better.
Using limit orders allows traders to select the specific price they want to execute trades. This gives you more control over slippage and helps to avoid losses due to unexpected cost changes during periods of high volatility.