What is slippage?

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I peruse many blogs and I like to read the comments. I came across a blog where someone commented on how he signed up to get “free” trades on zecco.com. I put free in quotes because there is no such thing as a free lunch. Free means you don’t get a brokerage statement with a commission charge. However you are still paying something in the form of “slippage”. If you fall for this free commission pitch you are being penny-wise and pound-foolish.

What is slippage?

By the book, slippage is the difference between estimated transaction costs and the amount actually paid. So assume you put in an order to buy 100 shares of Cisco when the stock is $25 and the bid is $24.75 and the ask is $25. What price will your order execute? If you have bad slippage you will get a price of $25 everytime you go to buy. If you click a buy at that same moment you are almost guaranteed to get a price of $24.75. You want fast execution and good price execution. You need a direct-access broker.

Direct-access brokers usually allow their clients to trade directly with an exchange or with other individuals via ECN’s. What this means is you get better fills of your orders more closely alligning to the market price. Orders are filled fast and with good pricing.

Penny-wise, Pound-foolish

So is $0 commission a bad deal? Well let’s take the above example. If you can get the buy in at say even 5cents less at $24.95, that’s $5.00 in savings. Now consider that for such a trade with a direct-access broker like Interactive Brokers (I use them) your commission would be $1.00. While your statement would show you paid $1.00 vs $0.00 with Zecco, you still saved $4.00. With a direct-access broker you have much better odds of getting fills between the bid/ask. With a full-service broker or a poor broker, you are almost guaranteed to fill your orders at the extremes of either the bid when selling or the ask when buying.

Not such a great deal after all. The impact gets even magnified in fast moving markets. You may see the spread (the difference between bid/ask) as .25 in the above example. What if it expands and contracts. When you see it you see a .25 spread, but it expands to say .35. All of a sudden you paid .10 more than expected or $10 more.

Another example where you may get unexpected pricing is on large orders. Say you enter a trade that is 5% of the trade volume. You see the spread as .25. When you submit your buy order, that order may not completely fill without a wider spread. You’ll get a poor spread and slippage. Slippage in the sense that what you calculated you’d get does not match what occurs in the market at the moment of execution.

So what do I do?!

• Use a Direct-Access Broker! Switch to a broker such as Interactive Brokers or Cybertrader. There are others out there. Do a Google search on Direct Access Trader and Barron’s to get Barron’s top brokers.
• If you have large volumes of shares to trade, split it up. Find an average price point and don’t dump your trade into the market in 1 big order. Split it up. Though you may end up paying more commissions, you are more than likely to save more on the better prices.
• Thank Dax. The best way you can thank me is by commenting on this blog about your experience. Good, bad, ugly… it doesn’t matter. I’d like to hear how my advice has helped or hopefully not… hurt your trading. I read every comment so I look forward to getting more.

Slippage is a dirty word. Direct-access brokers are the little secret your broker doesn’t want you to know about. I switched from e-trade to Interactive and never looked back. My orders were faster and with better prices. I used to wonder sometimes with E-Trade why my market orders were so far from the price at the time I clicked submit. I know now why. I hope you will take this lesson and benefit from it.

If anything, take some of your money and open another account with a direct-access broker. I’m sure you will notice the difference on the first few trades. You’ll never look back.