Measuring and avoiding slippage
System traders prefer to focus on the core of their strategies — entry and exit order logic. As such, an important but often-neglected factor in system development, backtesting and live trading is slippage. Slippage by itself can break an otherwise profitable trading system. Most momentum strategies, such as trend-following, get in and out of positions in the direction of the price momentum. This makes them especially susceptible to the negative effects of slippage.
Slippage simply is the difference between a theoretical entry price and the actual fill price. It can be measured in several ways (ticks, points, dollars, etc.). We'll address slippage from a relative point of view by measuring it in percentage terms compared to the range of the price bar. For any given order, the worst possible slippage would occur by buying at the high of the bar (or, conversely, selling at the low of the bar): This would represent 100% slippage on the order.
Slippage percentage is calculated by dividing "d1," the distance between the theoretical order entry price and the actual fill price, by "d2," the distance between the theoretical order price and the worst possible fill price. As an example, consider the following for a "buy" order:
Theoretical entry price: 1060
Actual fill price: 1064
Bar high (worst possible) long entry price: 1100
d1 = 1064 - 1060 = 4
d2 = 1100 - 1060 = 40
Slippage = d1 / d2 = 4 / 40 = 10%
This article will measure the effect of slippage and discuss ways to control it, including the use of different order types to improve success.