The Importance of Having an Execution Strategy

09/14/2009 11:19 am EST

Focus: STRATEGIES

Corey Rosenbloom

Founder and President, Afraid to Trade

Did you know you could save thousands of dollars per year in your trading activities just by being slightly more efficient with your trade entries?  Most traders practice poor trade execution skills, which might not seem like a big waste on an individual trade, but over the span of hundreds of trades per year, the difference really adds up.and you'll never see the savings unless you know where to look!

Let's take a look at how small tweaks in each trade you enter could wind up saving you hundreds or thousands of dollars depending on how active you trade and how sloppy your execution skills are.

Let's start first by defining "trade execution skills."

As a trader, we look for opportunities in the markets, and when we find one, we often get in the trade as soon as possible. The process of actual entry into a trade, whether using limit orders, market orders, bracket orders, or any other type of strategy including "hitting the buy button," falls under the umbrella of trade execution. "Execution skills" refer to the art or the precision with which we enter a trade.

Are we going to use a market order or a limit order? Are we waiting for the stock to hit an exact price or are we going to enter right now without hesitation? How much time should we wait between our signal and our entry? Are we maximizing the toolbars or order entry screens our software program provides for us or are we just hitting the "Buy it Now" button like on eBay?

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(Order execution bar example as seen in TradeStation)

These are some of the questions we want to answer well in advance of putting on a trade. Let's walk through a quick example before discussing specifics of trading tactics to underscore how important it is to develop and hone your trade entry skills.

Let's assume for a moment that, to enter a trade, you use market orders all the time to get your position filled in the markets. This means that the moment you hit the "buy" button, your order will be filled as soon as possible, which means you "pay up" for this privilege of speedy entry through a term called "slippage." Slippage occurs when we want to enter a trade and we pay the higher "offer" (or "ask") price to enter and the lower "bid" price to exit.

It's not common to get orders filled at the last price as seen on your screen, especially those greater than 1,000 shares if daytrading. Usually, you'll pay a few pennies higher than the last price when using market orders, and these pennies can add up quickly. Keep in mind that each penny difference between the last price and your fill price reflects slippage and is worth $10 per penny on each thousand shares you purchase.

If you buy and sell 1,000 shares at a time and trade in and out of a stock five times per day, and if you lose just two pennies to slippage on each trade entry, then you will be slipping $20 per transaction, which is $100 per day! If you trade the same way with five trades per day, that $100 adds up to $500 per week or $2,000 per month!

This problem is larger in more volatile stocks with wider spreads. Imagine what you could do with $2,000 in extra cash per month!

Factors Affecting Slippage

In fact, the following factors affect how much slippage you should expect to receive through using market orders:

  1. Volatility of the stock
  2. Liquidity of the stock
  3. Time of day factors
  4. Size of your position

The more volatile a stock is, the larger the amount of slippage you should expect. Google (GOOG) and Apple (AAPL) are more volatile and often have wider spreads than Wal-Mart (WMT).

The more shares traded in a stock per day, the less slippage you are likely to have. Highly liquid stocks that trade more than a million shares per day often have less slippage than stocks with thinner or less liquidity, such as those that trade less than 100,000 shares per day.

The time of day you trade affects your slippage also. Generally, all stocks are more active and volatile in both the morning open and the afternoon closing times. Although liquidity is higher, volatility is often higher as well, as prices jump quickly from one price to the next. Executing a market order at this time often results in slightly greater slippage than during a more moderate volume time. Also, stocks tend to stagnate and volume declines during the mid-day period, so you might have more slippage as a result of the lower volume that the lunch hour brings.

As mentioned earlier, if you use a market order with 1,000 shares, you are more likely to experience greater slippage than if you bought 100 shares of a stock. If you tried to purchase 5,000 shares all at once of a low-volume stock, you are likely to experience a surprise on your trading confirmation statement!

Keep these factors in mind when entering your order. Try to select highly liquid stocks with enough volatility to give you a chance for profit, and split very large orders into smaller pieces if possible.

MORE: Continue Reading Today's Lesson on Page 2 |pagebreak|

Market orders are not inherently bad, but we need not use them on each and every trade entry we take. The main alternative to market orders is limit orders, which are designed to try to cut down on some of the slippage that results when we can't wait to get into a position.

Limit orders allow us to specify a maximum price that the stock must hit to trigger us into a position, but prevents us from being filled at a price beyond what we are unwilling to pay. Limit orders help limit slippage by telling the market what we're willing to pay to buy a stock, which is also the price we're not willing to pay more than just to get in.

The benefit of limit orders is that we minimize large slippage on individual positions, which can certainly add up over time in the hundreds or thousands of dollars, but before abandoning market orders completely, let's take a look at a disadvantage of limit orders.

Say a stock you want to buy is rising very quickly and you want to enter a trade. If you used a market order, you would get filled right away and hopefully the price would keep rising with you on board, allowing you to make a profit when you sold the stock later. You would expect some slippage for this privilege of entering as soon as possible, which isn't felt immediately, and might never be felt at all if you don't look closely at your trade fills in comparison to what you thought you paid at the time of entry.

If you executed with a limit order, you would eliminate major slippage, but you might not get filled at all and the market would run away without you on board!

Sometimes, traders become disgusted with slippage from market orders and then switch to using limit orders exclusively. That's emotionally comforting because it prevents slippage, but again, if your use of a limit order prevents you from getting the trade on, then your opportunity cost by correctly identifying a trade set-up and failing to execute (get into the trade) what resulted in a successful trade would certainly cost more than the $50 or so you would have saved from slippage!

chart
Click to Enlarge

Let's say two traders see the exact same set up and expect the price of Apple Inc (AAPL) to run up at least $1.00 over the next few minutes. Price broke upwards from a descending triangle pattern, so both traders want to try to capture at least $1.00 from the expected price expansion out of the triangle. The trade signal was given roughly at $171.40 and the target is $171.40 (stop-loss under $171.00).

Trader Mark, who only used market orders, executed when price hit $171.40 and realized he had a slippage of five pennies on execution because he was filled at $171.45, or about $50. However, he was in the trade to watch as AAPL continued to rise higher. He also sold when he had a gain of $1,000 after AAPL rose $1.00 as expected.

Trader Lenny, who only used limit orders, set a fixed price of AAPL that was the current price of $171.40 as the market roared higher out of the triangle, leaving his limit order unfilled as he sat on the sidelines while AAPL achieved the $1.00 quick price move he anticipated happening.

At the end of the day, Mark had $1,000, which included $50 in slippage, but Lenny had failed to get his trade executed, resulting in a flat day.

Summary

So what is a trader to do? If market orders result in higher slippage, and limit orders result in missed opportunities, what is the solution?

My suggestion is not to use limit or market orders exclusively, but to be savvy in your trade execution skills to know when to be aggressive with market orders and when to be conservative with limit orders.

If you are expecting a large price move, or trying to play a runaway market or an expansion price thrust out of a known consolidation pattern (like a triangle or flag), then the primary goal should be to get the trade on! This means it is preferable to use market orders when price is making a large momentum swing or runaway move that could result in a decent profit, but that buyers are pushing the price higher so quickly, you need to get on board as soon as possible or you will miss the entire move.

In this case, accept the slippage because it will be worse to miss the trade by playing safe with limit orders in trying to avoid slipping away a small amount of money.

However, during a range day, or quiet market activity, or when you are trying to play for a smaller, very specific, very precise target (such as off a price divergence or fading a price extreme on a narrow day), then you would do best to use a limit order to save a little bit of money and limit slippage as much as you can.

You can't avoid slippage totally, and that should not be your goal. Your goal should be to minimize its effects as much as possible and apply the appropriate entry to the current market structure or situation (volatility level, trade target expectation, etc).

Even if you wisely used limit orders on half of your trades when in the past, you would have used market orders in flat, non-volatile market conditions, you can cut your slippage for the year in half, which still adds up to a lot of savings.

However, be careful about using strict limit orders in runaway momentum environments or strong impulse moves because you could cost yourself more than you save in the event that you miss trades that would have resulted in nice profits where your effort to conserve $50 left you sidelined.

Know what to expect in advance, and select the type of order entry strategy appropriately. In so doing, you will take back some of the hidden costs that most traders never know they're missing. Even small changes can add up big time over the course of a whole trading year!

By Corey Rosenbloom of AfraidToTrade.com

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