The Cost of Slippage
You’ve often heard us talk about the important of trading liquid options. Today we’ll put a dollar figure to this concept and show just how much “slippage” is costing you trading options that are illiquid. Specifically, securitiess that show a bid/ask spread of just $0.20 could end up costing you more than $3,840 each year - and that’s just the cost of getting into or out of the trade!
In this video, I want to talk about the invisible cost of slippage. Too often, I’ll hear traders complain and whine about their super high commission cost that their broker is charging them.
While these costs are undoubtedly an important part of your ability to generate a profit, there is a hidden troll that is stealing much more than your broker, and you don't even know about it most of the time.
One of the main things you’ll hear professional traders harp on is the idea of trading products with high liquidity. There’s a reason I care so much about liquidity besides the ability to quickly enter and exit trades which of course is nice in any market.
As you'll see, it all comes down to slippage. Slippage is the seemingly low dollar amount, and often invisible or unfelt amount you lose on each trade due to the bid-ask spread differential.
In this video, we’ll show you why slippage and poor underlying stock selection cost you nearly $3,800 each year on the low end. Let’s first take in an example here by looking at SPY slippage.
SPY is the ETF that tracks the S&P 500 and one of the most active, highly traded securities out there. You can see that the SPY has a daily volume of around 74 million contracts or more. Just at the time that we took this video, it’s about 74 million contracts that were being traded.
You can see most of the options that it trades have bid-ask spreads that are about a penny wide, so 104 to 105. Even options that are far out of the money are at most about two pennies wide, 62 to 64.
It’s very tight markets, and that's because of the high liquidity and open interest on both sides. You can see the market breath, and the market depth is there for SPY. The same thing is true of other non-ETF securities like Apple.
Apple is a highly traded security. At the time of this video, it’s just about the afternoon, and it had about 32 million contracts or shares traded in the underlying stock.
The options on both sides are highly liquid with a lot of volumes and open interest, and you can see that options that are at the money are trading with a penny wide or two pence wide bid-ask spread, so very, very minimal slippage.
Now, even with these incredibly tight bid-ask spreads, we’ll still lose money on a slippage trade with these super liquid options. Here's how the math works out exactly.
If you have a penny wide bid-ask spread and you times that by a contract multiplier which is 100 because we always times the option price by 100 to get the true value, and we times that by just one contract that we’re trading and two sides of the trades.
So we have to open a trade, and we have to close a trade, so just one contract that we’re trading in Apple or SPY, an open and a closing trade, we’re going to lose about $2 per trade just in the slippage.
This means that every single time we trade just one option contract in either Apple or SPY, we’re likely to lose just $2 per contract in slippage. That means if we traded each stock just one time each month for an entire year, we lose a total of $48 in slippage.
Don’t let this deter you, though. The profits we generate trading just one spread are likely more than going to cover the slippage and commission cost each year. But what about other stocks that are out there?
What about other stocks that maybe don't have the high liquidity that Apple and SPY have? If stocks like Apple and SPY still cost us $48 per year in slippage, I wonder what slippage cost of a non-liquid stock options are going to be?
Let's take a look at an example. In this example, we’re going to use Nike which is ticker symbol NKE. Nike is a big-name security, and you can see at the time of this video, it had about a million shares of its underlying stock traded that day.
And the bid asks spread is much wider in Nike than it is in Apple or SPY, almost ten times wider. You can see that the at the money puts were trading about a $.10 bid-ask spread and then on the at the money calls, we were looking at about a $.12 bid-ask spread.
Here's how the math works out on Nike with this higher bid-ask spread. We have the $.10 bid-ask spread differential, times the 100 contract multiplier, times just one contract on two sides because you have to open and close the trade.
That means that with Nike, you’re losing $20 per trade in this bid-ask spread differential. Every single time that we trade just one single option contract with Nike, we’re losing $20 to slippage. Talk about starting out in a whole, right?
You wonder why most traders don’t ever make money in this business. I mean, this is one of the key points here that most people get wrong, is this ability to trade liquid products. Here's the thing. If we traded Nike just one time each month for a year, we would lose $240 in total. That’s one stock and 12 trades.
But wait. It gets better because there are stocks out there like AVB which people will undoubtedly trade. You can see that the open interest is not nearly as much as Apple and SPY, but there’s a market for AVB options.
You can see that the stock has much less volume of the underlying shares and the bid-ask spread can be anywhere between $.40 and $.50 wide. Here's how the math works out on AVB.
The $.40 bid-ask spread, (just taking the most conservative approach here) times the 100 contract multiplier, times one contract, times two sides to get in and out, you’re losing $80 per trade. $80 per trade just due to the wide bid-ask spread.
This is truly insanity. If we traded AVB just one time each month for a year, we would lose $960 in total. This is just trading one particular stock that has really bad liquidity.
I’m sure by now, you’re starting to see how important liquidity is to professional traders and it should be to you if you want to be successful trading options.
But let’s take this one step further. Let's assume that you are slightly more active than just making 12 trades a year. If you’re like most options traders, you’re likely making four to five trades a week and spreads of course.
You’re trading credit spreads and debit spreads and iron condors, and you’re trading strangles and straddles. You’re not just trading one option.
Let's just use some average bid-ask spread that’s out there around $.20 which I think is more than reasonable. We could probably even argue that the average bid-ask spread much higher than that.
Let’s use a $.20 bid ask spread, times 100 multiplier for the contract, times two contracts if you’re trading just a credit spread or a debit spread, times two sides to the trade because you have to get in and out of that trade, times four trades a week, times 12 months out of the year and you end up with a total cost of $3,840.
Congratulations! If you're the average investor with an account size of approximately $10,000, you just lost 38% of your account due to slippage cost of trading illiquid options alone.
I’ll just let that sink in there for a second, just how much it would cost you as a new trader or even a trader that’s been in this business for a long time. Liquidity is a huge component to your ability to be successful.
As you can see, even if your broker were charging you $10 per contract or $20 per contract, it wouldn’t come close to the invisible cost of slippage that drains your portfolio. The good news is that you now have the knowledge to completely avoid this.
Because trading liquid underlying stocks is at the heart of any successful options trading system including ours, you now can go out there and look for securities that have amazing liquidity.
But if you don't have the time to do that or if you don’t want to do that, we do offer a copy of our own prescreened and pre-scrubbed watch list that you can purchase. If you're interested in purchasing a lifetime pass to our watch list of the top 50 plus liquid stocks with options that we trade.
Just click the link below this video, and you'll be taken to our website at Option Alpha. Once you have a lifetime pass to this watch list, we send out an update to everyone who's ever purchases before in the past, letting you know if stocks seem to have better liquidity or less liquidity every single month.
We will always update this watch list as new stocks come in and as current stocks fall out of favor with the market and with liquidity. As always, I hope you guys enjoy this video.
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As always, if you guys have any comments, please ask them right below in the comment section to this page. Until next time, happy trading!
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