Spread, slippage and the real cost of trading

A trading idea is tested twice. Once against the market, where it may or may not have an edge, and once against the costs of expressing it, which are certain. The second test is lost more often than the first, and it is lost quietly.

The spread

The difference between the price at which an instrument can be bought and the price at which it can be sold is paid on every round trip, without exception. On a liquid index product during the main session it may be a fraction of a point. That fraction multiplied by a hundred trades a month is no longer a fraction. The more frequently a strategy trades, the larger the edge it needs just to cover the toll, and many strategies that look attractive before costs are simply transferring money to the venue.

Slippage

Slippage is the gap between the price a participant intended and the price they received. It is small on resting orders in quiet markets and large on market orders in fast ones. Stop orders, which are by design triggered when the market is moving against the position, are the orders most exposed to it. Brokers that publish execution statistics typically show that stops in index products fill worse than requested a meaningful share of the time, and worse still around economic releases and the open.

Slippage is also where simulated results and real results part company. A simulator that fills every order at the intended price is not modelling a market; it is modelling a wish.

Speed is rarely an edge

Participants sometimes conclude that the answer to slippage is speed. For most, it is not. The fastest participants in modern markets operate in microseconds from inside the exchange's own building, and no strategy run over an internet connection competes with them. A strategy that only works if it is executed within a few hundred milliseconds is a strategy that will not work. The useful test is the opposite one: does the idea still hold if execution is delayed by a second? If it does not, the edge was never really there.

Measure it

The only cure for costs is to know them. That means recording, for every trade, the price at the moment of decision and the price actually received, and then comparing the two over hundreds of trades. The resulting number, sometimes called implementation shortfall, is the true cost of a strategy, and it belongs in every evaluation of whether the strategy should exist.

The cheapest trade is the one not taken. The second cheapest is the one whose costs were counted first.