Tuesday, October 30, 2012

Slippage - The Day Trader's Scourge

When I first began to day trade, I was not too worried if some of my trades suffered a bit of slippage. It hardly detracted from the feeling of pleasure in a winning trade, or the feeling of pain in a losing trade.

Slippage typically occurs when I issue a market order to buy at, say, 1450, but my order is filled at some worse price, say 1450.5. Beneficial (positive) slippage is also possible if, for instance, the fill comes back at 1449.75.

The opposite applies for a short trade. If I issue a sell order at 1450, I have 2 pips of negative slippage if I am filled at 1449.5, or 1 pip of positive slippage if I am filled at 1450.25.

However, as time passed, I came to realise that slippage is my greatest enemy. The reason is that it is my most significant cost. In any business, cost control is important, and trading is certainly no different.

In general, a day trader is targeting a smaller profit than a long-term trader. If I enter a trade targeting 2 S&P E-mini points ($100 per contract), I have one inescapable fixed cost, the brokerage commission (say, $5, or 5% of my targeted profit).

However, if I suffer slippage on the trade, things turn ugly. 1 pip of slippage costs $12.50 per contract, 2 pips cost $25, that is 25% of my target profit! These are substantial bites out of my potential return.

Often, it is worse for losing trades. If I have a risk/reward strategy of 1:2, I would anticipate losing $50 if the trade hit my stop loss exit point. Now, the $5 commission represents 10% additional loss, and 2 pips of slippage ($25) represents a massive 50% of additional loss.

The fact is, with 2 pips slippage, I stand to make just $70 on a winner, and to lose $80 on a loser. My projected 1:2 risk/reward ratio, which may have seemed quite attractive, has been savaged. It is now an 8:7 risk/reward ratio; I am risking more than I hope to gain!

My style of day trading involves analysing trading setups which have yielded profitable outcomes over a long period. While what has worked in the past cannot be guaranteed to work in the future, it is my belief that it can be a powerful guide, getting me into trades with a higher probability of a successful outcome.

But in analysing past results, I had better make realistic assumptions about the slippage I can expect on my trades. A strategy that may look like a potential winner with no slippage can very easily turn into a long-term losing strategy if slippage is anticipated.

I use a simulator to back-test strategies that I think have good potential. In a recent blog post, I discussed a possible wheat strategy. I back-tested the strategy from April 2009 through to July 2012. With no slippage, the return was an excellent 228%. But with an average 1 pip of slippage per trade, this came right down to 95%, and with an average of 2 pips slippage, the return was −37%!

One way of avoiding slippage is to enter your trades with limit, instead of market, orders. Limit orders certainly will cure the slippage problem, since your order is not filled at a worse price then you have requested. Unfortunately, the gains made by avoiding slippage can easily be lost by missing winning trades when price moves so quickly that the limit order isn't filled.

Another way of mitigating slippage is to use "smart" entries. By this I mean making use of your knowledge of the market to enter at a level which you know will trigger a fight between bulls and bears. If your market order is placed early in the fight, it is likely to be filled at, or close to, your target entry point. You may even be fortunate enough to receive positive slippage!

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