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GIVEN THE SLIP

How can I best ensure against slippage on an option order?

If you’ve been trading long enough, you probably have learned about slippage the hard way. Two good ways to guard against this enemy of profits is to deal in options with strong liquidity characteristics and stay clear of market orders whenever possible.

As for a stock’s options providing strong liquidity: Average daily contract volume, large open interest, and tight quoted call and put markets are the three components that we can use as measures against unjust slippage. Having one of these characteristics in place is no guarantee of the other two. Without all three in place, without a contract month that’s new to the board, there’s a strong chance that what looks to be worth trading today, all else being equal, might not be so at a later date.

In the end, slippage costs us capital as it takes away from our bottom-line results.In addition, you might want to go back to earlier trading sessions and look at contract volume on any given day. Knowing how both larger and smaller traders are vested is better than a situation with the same volume but with all the activity stemming from one group. Block prints that occur with regularity can paint a distorted picture of liquidity, for example, as could a large amount of retail trading that’s there one day but gone the next due to the likes of a newsletter recommendation.

In the end, slippage costs us capital as it takes away from our bottom-line results. Fortunately, traders can run scans to weed out slippage risk. A simple starting point would be to use a benchmark 50-day simple moving average of option activity in a stock trading 3,000 contracts on a daily basis. You may want to use this as a filter on stocks already on your watchlist, whether the common bond is upcoming earnings, a sector of interest, or some sort of technical or fundamental correlation.

Your broker or software platform might also allow you to put in option-related parameters such as the average spread or bid/ask percent distance for near-the-money options. In my experience, 5% to 7%, along with a stock that trades more than 3,000 contracts daily, should provide the type of environment in which your orders have the opportunity to get filled midmarket or for essentially fair value and remove potential slippage issues both entering and exiting.

Another way to avoid slippage is to use limit orders rather than market orders. Remember, you can always place a limit price that’s below the current market for a sale or above the offered price for an option or spread that’s being purchased. Unlike with a market order, a limit order allows traders to know what their worst-case fill would be when an order gets executed outside the quoted market. If a trader is unrealistic about the limit or uses the order during a fast or unstable market condition, he or she runs a risk of not receiving a fill.