Slippage

---

Slippage in Options Trading

Slippage in options trading refers to the difference between the expected price of a trade and the actual price at which the trade is executed. It can occur in any trading scenario, whether buying or selling options. High slippage is most prevalent during periods of higher volatility and low liquidity.

You are almost always paying slippage, and its effect reduces your winners and adds to your losers – so understanding how to minimize it in your trading is critical to success. You might consider that slippage is the fee you pay to enter a trade and you pay again to exit a trade – and the fee is likely going to a Market Maker to provide you with this instantaneous liquidity (your fill). If you need to get in now, you are going to pay a bit higher price, and if you need to get out now, you are going to have to accept a lower price – that is slippage.

When you open a brand new trade and instantly the broker shows your position as negative – that is the slippage.

Slippage is everywhere – buying and selling a house has a bid-ask spread, and real estate brokers with 6% commission on both buy and sell trades. Slippage shows up in currency exchange rates and the different prices of gasoline in a 50-mile radius – how convenient or urgent do you need your gas?

Key Takeaways on Slippage:

• Avoid market orders and instead be patient at the mid
• Look for high open interest, high volume, tight bid/ask spreads, with a lot of quoted contracts
• Volatility and events can drive up slippage costs
• Higher priced contracts (ITM) pay a lower proportion of slippage relative to cheap contracts (OTM)
• Higher number of contracts traded doesn’t help lower slippage on a percentage basis
• Higher frequency of trading causes a compounding effect of slippage costs
• Stop and Limit order types don’t prevent slippage – they wait for the market to move enough to cover the costs

Common Reasons for Slippage:

• Changes in the bid/ask spread between the time a market order is requested and the time it is executed.
• Large orders being executed but not enough volume at the chosen price.
• Rapid price movements that result in orders filling at significantly different prices.
• Not enough market participants at the bid/ask willing to trade at or around the mid price.

Strategies to Minimize Slippage:

1. Use limit orders: Limit orders allow traders to set a maximum or minimum price at which they are willing to buy or sell an option. This ensures that they will only execute a trade at their specified price, reducing the chances of experiencing slippage.
2. Trade highly liquid assets: Highly liquid assets have narrower bid-ask spreads, which can help reduce slippage. Trading in markets with high liquidity can limit exposure to slippage.
3. Pay attention to execution speed and accuracy: Faster execution speeds translate into smaller amounts of slippage. Choose a reputable broker with fast and accurate trade executions to minimize slippage.
4. Trade during active market hours: Trading during periods of high market activity can increase the chances of your trade being executed quickly and at your requested price. Avoid trading during volatile periods or when liquidity is low.
5. Avoid large orders: Large orders can cause significant price movements, leading to slippage. Breaking a large order into smaller, more manageable sizes can help reduce the impact of slippage.
6. Track the underlying assets which have highly liquid options chains and focus your strategies on this basket.
7. Let short options positions expire worthless rather than closing them.
8. Avoid trading too often which causes a round-trip slippage cost.

Impact of Slippage on Trades

Slippage can impact your profit and loss on winning and losing trades in several ways:

• Negative slippage: When a trade is executed at a worse price than expected, it can result in a larger loss than anticipated. For example, if you place a market order to buy an option at $10 per share, but the order is executed at $10.05 due to slippage, you will incur an additional loss of $0.05 per share.
• Positive slippage: When a trade is executed at a better price than expected, it can result in a smaller loss or a larger profit than anticipated. For example, if you place a market order to sell an option at $10 per share, but the order is executed at $10.05 due to positive slippage, you will realize an additional profit of $0.05 per share.

Calculating Slippage in a Trade

In the given scenario, you pay $1.00 for a call option with a bid-ask spread of $0.95 / $1.05. To calculate the total slippage when entering and exiting the trade, you can follow these steps:

• Entering the trade: When you buy the call option, you pay the ask price, which is $1.05. The difference between the bid price ($0.95) and the ask price ($1.05) is $0.10, which represents the slippage when entering the trade.
• Exiting the trade: When you sell the call option, you receive the bid price, which is $0.95. The difference between the ask price ($1.05) and the bid price ($0.95) is $0.10, which represents the slippage when exiting the trade.

Total slippage = Slippage when entering the trade + Slippage when exiting the trade Total slippage = $0.10 + $0.10 Total slippage = $0.20

Slippage Is a Drag on Winning Trades

• You want to buy a call with a mid-price of $1.00, the bid/ask is $0.97 / $1.03.
• You place a limit buy at $1.00 but can’t get a fill.
• You adjust your price to 1.01 and can’t get a fill.
• You adjust your price to 1.02 and get filled.
• (Several moments later)
• You want to sell the option for $1.20 and enter a limit price of $1.20 but can’t get a fill.
• You adjust your price to $1.19 and can’t get a fill.
• You adjust your price to $1.18 and get a fill.

-$102 +$118 = $16 of profit on the trade. You might have expected to receive $20 if you assumed you would get the “mid” price on your entry and your exit. Slippage reduced your total profit by 20% – you made 16% not 20%.

Slippage Adds to Losses on Losing Trades

• You want to buy a call with a mid-price of $1.00, the bid/ask is $0.97 / $1.03.
• You place a limit buy at $1.00 but can’t get a fill.
• You adjust your price to 1.01 and can’t get a fill.
• You adjust your price to 1.02 and get filled.
• (Several moments later)
• You want to sell the option for $0.80 and enter a limit price of $0.80 but can’t get a fill.
• You adjust your price to $0.79 and can’t get a fill.
• You adjust your price to $0.78 and get a fill.

-$102 +$78 = -$24 of profit on the trade. You might have expected to lose $20 if you assumed you would get the “mid” price on your entry and your exit. Slippage increased your losses by 20% – you lost 24% not 20%.

Could you be profitable playing poker if the table had a 20% rake? Or a casino that charged 20% of your winnings and a 20% fee for your losses? No. This is why the bid/ask spread and other factors affecting slippage are so important – especially in options trading because of the many factors impacting the high cost of slippage.

Factors Affecting Slippage

Traders can estimate the amount of slippage they may incur in a trade by considering the following factors:

• Bid-ask spread: The difference between the highest bid price and the lowest ask price is the bid-ask spread. A wider bid-ask spread indicates higher potential slippage.
• Tight bid-ask spreads with many contracts on both sides = low slippage.
• Market volatility: High market volatility can lead to higher slippage, as rapid price movements can result in orders filling at significantly different prices and a distortion of the true mid-price.
• Liquidity: Low liquidity in a market can cause a longer time gap between the placement and execution of an order, leading to a higher chance of slippage.
• High volume, high open interest = tight bid-ask spreads = low slippage.
• Order type: Market orders are more susceptible to slippage than limit orders, as they are executed at the current market price, which can change between the time the order is placed and when it is executed.
• If you have wide bid-ask spreads and you use market orders, you might be paying up to 50% in your total potential profit in slippage – these trades are very hard to win.
• Trade size: Larger trade sizes may experience more slippage due to the increased demand for the asset, which can cause price movements.
• News events: Slippage often occurs around significant news events, such as interest rate announcements, earnings reports, or changes in management positions.
• Execution speed and accuracy: Faster execution speeds translate into smaller amounts of slippage. It’s essential to choose a reputable broker with fast and accurate trade executions to minimize slippage.

The Number of Contracts and Price of Contracts Relative to Slippage

There is another important aspect to discuss: the ratio of the asset to the bid-ask spread.

• Contract A: 0.95/1.05 is a $0.10 cent spread relative to a $1.00 mid-price. That is 10%.
  • If you use market orders to trade A for a 20% gain relative to its mid-price, you will have:
  • (-$105 + $115) = $10/$100 = +10%
• Contract B: 9.95/10.05 is a $0.10 cent spread relative to a $10.00 mid-price. That is 1%.
  • If you use market orders to trade B for a 20% gain relative to its mid-price, you will have:
  • (-$1005 + $1195) = $190 / $1000 = +19%

Even though the real price of the slippage of $10 is the same, the effect on the return is drastic when comparing a $100 contract and a $1000 contract. This applies to equities as well – a low volume small-cap stock with a low price and wide bid-ask spread will put your trade in the red 1-5% upon entry if you pay the ask.

Slippage Scales With the Number of Contracts

Let’s run it back and do a quantity of ten of contract A versus one contract of B so that each trade is worth $1000.

If you use market orders to trade 10 of contract A for a 20% gain relative to its mid-price, you will have 10(-$105 + $115) = $100/$1000 = +10%.

This still underperforms trading one contract of B – with a tighter bid-ask spread relative to contract price. Adding more contracts doesn’t impact the per contract percent of slippage for each of them in the order.

Slippage Compounds With Frequency

The frequency of round-trip trades can impact slippage on a percentage basis over time, as it can compound the effect relative to the overall account size. Here’s how:

• Higher Trading Frequency: High-frequency traders execute a large number of trades, which can result in higher trading costs due to slippage. As the number of trades increases, so does the impact of slippage on the overall account size.
• Risk to Slippage Ratio: Relative to the amount of risk, trading less frequently will lower the impact of slippage on a portfolio over time. Let’s assume a $1,000 account size:
  • One 10% positive trade win paying 2% slippage has $1,080 at the end of the year, paying 25% ($20/$80) of gains in slippage.
  • Five 2% positive trades win paying 2% slippage have $1,000 at the end of the year, paying 100% of gains as slippage.
  • Five 7% positive trades win paying 2% slippage on each have $1,276.28 at the end of the year, paying $126.27 in slippage which is 45.70% of total gains ($126.27/$276.28).

But My Stops and Limits Mean I Don’t Pay Slippage?

This is a fallacy. If you have a limit buy at $1.00 and a limit sell at $1.20 and both of those fill, it might seem like you didn’t pay slippage, but if you paid closer attention, you would see the quoted mid-price at or around $0.98 on your entry and at $1.22 on your exit. You could have made $24, but you only made $20 because you still paid $4 in slippage – the market just moved farther than it would have otherwise needed to in order to compensate you for the cost of slippage.

In Conclusion

The relationship between liquidity and slippage in options trading is such that higher liquidity leads to lower slippage, while lower liquidity results in higher slippage. Market orders, low volume, large trades, and high volatility can all lead to greater slippage costs. Traders should be aware of this relationship and understand that slippage is an often overlooked reason why your gains aren’t as big as you thought and your losses are worse than expected.

---