Entry Problems for Day Traders

If you are one of those traders who buy at support or sell at resistance, then your entries take care of themselves. But if, like me, your strategy is to trade breakouts through support and resistance levels, then the economics of your planned trade may very well be perverted by slippage.

Suppose you see price rising toward resistance at 900 and your strategy is to sell near the resistance level. Your plan may be to sell one pip below resistance at 899.75, with a 1.5 point stop at 901.25, taking profit at 895.25. To implement this you place a sell limit order at 899.75, a buy stop order at 901.25, and (after the trade is entered) a buy limit order at 895.25. There will be no slippage on a winning trade because if a limit order is filled you are guaranteed your specified price (or better).

If the trade works, you make 4.5 points profit, which is three times your planned risk of 1.5 points.

On the other hand, if you are a breakout trader, your plan may be to buy one pip above resistance at 900.25, with a 1.5 point stop at 898.75, taking profit at 904.75. You implement this by placing a buy stop order at 900.25 to enter your trade. Once you are in the position, enter a sell stop order at 898.75 to protect your trade, and a sell limit order at 904.75 to take your profit.

Again, if the trade works, you hope to make 4.5 points profit, three times the risk of 1.5 points. So essentially in both strategies you are planning trades at the resistance level with a potential 3:1 reward to risk ratio, quite a reasonable plan of attack. Here is where trading practicalities start to creep in…

First of all, that 4.5 points of profit is not going to be quite 4.5 – it will be 4.5 points less commission on the trade. Using a good deep discount broker helps to minimize this problem.

Secondly, in both cases, that 1.5 point risk assumes your stop loss order will be executed at exactly the price specified. In the markets I trade (grain futures), there is more likely to be one or two pips of slippage, sometimes more. What this means is that if a sell stop order at 898.75 is triggered, my actual fill may be at 898.25. This is a feature of stop orders where execution at the specified price is not guaranteed. In fast moving markets, the fill price can be quite a distance from what you expected.

If the trade fails, and there is 2 pips of slippage on the stop loss, the reward to risk ratio becomes 4.5 points profit to 2 points of risk, closer to 2:1 than the 3:1 you wanted.

It is worse for the breakout trader, because he or she enters the trade with a stop order, which may also suffer slippage.

In the breakout trade described above, entry was made with a Buy stop order at 900.25. Suppose the market is moving quickly when resistance breaks, so you suffer two pips of slippage and get filled at 900.75. Sticking to your original plan to take profit at 904.75, your target profit is reduced from 4.5 to 4 points.

In a losing trade, the breakout trader can be hit with slippage both ways. The entry might be filled at 900.75, and then slippage might see the stop filled 898.25. In this scenario, the planned 1.5 point risk has blown out to 2.5 points. In fact, given 2 pips of slippage on the entry, I am now risking 2.5 points for a potential 4 point profit. My comfortable 3:1 reward to risk ratio has been ravaged by slippage and is now just 1.6:1! 

These problems are of most significance to day traders because they work with small profit targets. Obviously, longer term traders shooting for 50 or 100 points of profit are not going to be worried so much by a couple of pips slippage, but for the day trader – particularly using a breakout strategy – it is the greatest single trading cost.

Can anything be done about it?

The first thing is to recognize and understand the problem. Personally, I accept slippage as a fact of life, and I make sure my theoretical reward to risk ratio is big enough to ensure that it is still worthwhile after slippage. You need to understand that what you may think is a 4:1 ratio may very well end up as 2:1 in real life.

Some traders I have mentored try to get over the problem by simply shifting the goal posts. They adjust the profit and stop levels around the specific entry achieved. In the example we have been considering, the desired entry for the long trade was 900.25, but the fill after stoppage was 900.75. These traders simply adjust the target to 905.25 and the stop loss to 899.25, maintaining the 4.5 point profit target and the 1.5 point risk level. This approach is OK, except that is might distort some important logic of the trade. For example, your original stop level may have been chosen because it was just below a support level, or it may have been at some important fibonacci level. This technique should ensure that potential profit is not reduced by slippage, but of course the stop loss order could still suffer slippage if the trade fails.

Another trader I know uses stop limit orders to ENTER trades. Effectively, the stop limit order lets you control how much slippage you are prepared to tolerate. You can even specify a stop limit order which will only be filled if it can be executed at your specified price (zero slippage). When I use them, I normally allow one pip of slippage. The danger is that the market moves through the breakout level so quickly that your trade can not be executed at all and you miss the trade completely. On the other hand, you often find that there is a bit of a pullback after a fast break through resistance (or support) levels, so stop limit orders may often be filled some time after the original break.

One thing you must NEVER do is use a stop limit as a stop loss order. You want stop loss orders to be executed even if the market is moving fast and you get significant slippage. Better that than having to watch the market continue to rocket away from you and your losses mounting. If you want to try stop limit orders, use them only for entering positions. Then, if the market trades right through the order, the worst that happens is that you miss out on a trade.

(Note that the examples in this article are based on the grain futures contracts which are similar to the S&P 500 emini futures contract. The smallest unit of price change is a pip, which is 0.25 cents. 1 cent is generally referred to as a point, equal to 4 pips. A move of 1 point represents a profit or loss of $50. Therefore, a profit of 4.5 points represents a profit of $225 per contract held.)

 

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