It doesn’t matter if you buy stocks or mutual funds or ETFs. You still need to think about “slippage”. But what is slippage and why should you care?
What is Slippage?
Slippage is the difference between what you expect to pay for a stock or ETF and the actual price you get. It is also the difference between what you expect to sell a stock or ETF for and what you actually receive.
Once you get a price quote, why is there a difference between that quote and the actual executed price?
There are a few reasons to explain why there will almost always be a discrepancy between the quote and the actual price. First, if you are buying or selling a very widely held stock or ETF, there could be thousands of trades that are executed every hour. Each trade has the potential to move the price in either direction.
So even if your trade is executed a few seconds after you place it, there could have been a few trades that went off in between the time you looked at the price and the time your trade was placed. If you are looking at delayed quotes, the likelihood of a price differential is even greater. That is why the price could have moved between the time you got a quote and the time your order is placed. That’s one example of slippage.
Another issue is liquidity. Liquidity refers to the number of shares that are traded on average each day. A highly liquid stock is one that changes hands quite a bit during any one day. Because there is so much demand and supply, the price is relatively stable for a short-period of time. That means the slippage is likely to be minimal.
If on the other hand the stock is illiquid you should expect quite a bit of slippage. Why? Because if fewer shares are traded, your trade could be the one that really pushes the price up or down. Let me give you an example.
Let’s say you place an order to buy 100 shares of XYZ, a highly liquid stock. There are millions of shares traded each day so it’s very likely that when you want to buy, there will be an order to sell at or near the last traded price. As a result, you’ll probably get your shares at or near the last quoted price.
Slippage is also a big problem with discount brokers. They often have rock bottom prices – and rock bottom execution as a result. So you might save a few dollars on commissions but pay hundreds more for the stocks you buy. To make sure that doesn’t happen, check out Scottrade Online Broker. They have consistently provided customers with prices that are even better than the national averages.
But when you buy an illiquid stock, you are at the market’s mercy. Let’s say you place an order for 100 shares of ABC which is thinly traded. When you place your order, assume there doesn’t happen to be any sell orders at the same price that last person traded.
While you see a quote for $10 (for example) the next person who is willing to sell may have a minimum price of $10.50 for her shares. That means if you have a market order for 100 shares, your price will be $10.50. That is an example of slippage.
If a stock trades less than 10,000 shares a day, you’re going to have to deal with slippage. And the problem gets worse because such thinly traded shares are usually pretty cheap. That means you will likely place an order for many thousands of shares for a cheap thinly-traded stock vs. a higher priced, more heavily traded security. When you place a trade for thousands of shares and the price slips by even 10 cents a share, that adds up to a lot of cabbage.
Most individual investors who buy highly liquid shares don’t have to worry too much about slippage but mutual funds do even if they buy very liquid stocks. Why? Because when they buy shares, they buy a lot of them. So if GRT Mutual Fund places an order for 100,000 shares of XYZ stock, it’s likely to move the price of the shares up. This is slippage too and it’s one cost of owning mutual funds.
Slippage with ETFs & Mutual Funds
Heavily traded ETFs are just like heavily traded stocks. Nothing to worry about in most cases. But thinly traded ETFs expose you to the same slippage problem that thinly traded stocks expose you to. Beware.
Mutual funds are traded based on end-of-day pricing. That means the value of a mutual fund is determined after the market closes by adding up the value of all the securities it owns less the mutual fund expenses. You don’t have to worry about slippage when you buy or sell a mutual fund. But as I said, slippage is a cost of buying and selling lots of shares. The more a mutual fund or ETF trades, the greater the slippage and the greater the cost to the investors. Since ETFs generally don’t do that much trading, slippage is generally less of a problem.
How to make sure slippage isn’t a problem for you
First, make sure that you trade liquid shares. Check Yahoo.com or some other financial site to identify the daily average number of shares traded and stick with those that trade 10,000 at the very least. I personally suggest that you not touch a stock unless it trades at least 50,000 shares a day.
The second thing you can do to mitigate slippage costs is to place limit orders on your trades. That means you don’t place market orders and take whatever price you get. Instead, you set a price above which you will not pay. If there is no matching order to buy or sell at the maximum you are willing to pay or minimum you are willing to sell for, your trade will not be executed.
It’s smart to understand how slippage works but it’s even more important to have a smart investment strategy worked out. Have you ever experienced slippage? Where you surprised? Did it change the way you invest?