Slippage & Commissions

Slippage and commissions are the real-world transaction costs that erode trading profits. A backtest that ignores them is fiction.

What They Are

Slippage is the difference between your expected trade price and the actual fill. You want to buy at $50.00 but get filled at $50.05. That $0.05 is slippage. It happens because:

  • Markets move between decision and execution
  • Your order moves the market (market impact)
  • The bid-ask spread means you buy at the ask and sell at the bid
  • In fast markets, prices gap past your intended level

Commissions are broker fees for executing trades:

  • Per-trade fees (e.g., $1 per trade)
  • Per-share fees (e.g., $0.005 per share)
  • Percentage-based fees (e.g., 0.1% of trade value)
  • Exchange, regulatory, and clearing fees

Other costs often overlooked:

  • Bid-ask spread: The most significant hidden cost. A $0.02 spread on a $50 stock is 0.04% per round trip.
  • Market impact: Large orders move the price against you. 100 shares — minimal impact. 100,000 shares — significant.
  • Borrowing costs: Short selling requires borrowing shares at 1-10%+ annually for hard-to-borrow stocks.
  • Financing costs: Leveraged positions incur interest.

Why Costs Kill Strategies

Transaction costs are the #1 reason strategies that look profitable in backtesting fail live.

  • Death by a thousand cuts: 500 trades/year with $5 slippage + $2 commission per trade = $3,500 in annual costs. That’s 7% drag on a $50,000 account.
  • Destroys high-frequency strategies: A strategy expecting 0.05% per trade is destroyed by 0.10% round-trip costs.
  • Asymmetric impact: Costs reduce every win AND increase every loss. This compounds.
  • Changes rankings: Adding costs often reverses which strategy is “best.” Highest gross return doesn’t mean highest net return.

Cost Impact by Trading Frequency

FrequencyTrades/YearRound-Trip CostAnnual Drag
Monthly rebalance240.10%2.4%
Weekly1040.10%10.4%
Daily5040.10%50.4%
Intraday (10/day)2,5200.05%126%

A daily strategy needs over 50% gross annual return just to cover costs at 0.10% per round trip. This is why most profitable retail strategies trade weekly or less.

Concrete Examples

The Profitable Strategy That Isn’t

Backtest without costs: 18% annual return, Sharpe 1.2, 400 trades/year. Average trade size: $10,000. Realistic costs: $2 commission + 0.05% slippage = $7 per trade. Annual cost: 400 x $7 x 2 (entry + exit) = $5,600. On a $100,000 account: 5.6% drag. Net return: 12.4%. Sharpe drops from 1.2 to ~0.8.

Still profitable — but the trader sized positions expecting 18%, not 12.4%. The drawdown may now exceed their tolerance.

Small-Cap Scalping Disaster

A small-cap scalping strategy shows 80% annual return with zero costs. The stocks have wide bid-ask spreads ($0.05-0.20 per share). With $0.10/share slippage and 2,000 trades/year at 1,000 shares each, costs eat $200,000. The strategy goes from +80% to deeply negative.

Bid-Ask Spread in Forex

A EUR/USD strategy using mid-prices captures 5 pips average profit per trade.

  • Backtest: 5 pips profit
  • Reality: ~0.5 pip spread on entry AND exit = 1 pip total cost
  • Net: 4 pips (20% reduction)

For EUR/TRY with a 10-pip spread, the same strategy loses 5 pips per trade. Profitable becomes unprofitable just from the spread.

Market Impact on Large Orders

An institutional strategy backtested with $50M AUM shows 15% return on mid-cap stocks. Executing $500,000 in a stock trading $2M daily moves the price 0.5-1% against you. Real market impact cuts returns to 8%.

How to Model Costs

Realistic Slippage Estimates

MarketSlippage Per Side
Large-cap US equities0.01-0.05%
Mid-cap equities0.05-0.15%
Small-cap equities0.10-0.50%
Major forex pairs0.5-1 pip
Crypto (major)0.05-0.10%
Crypto (altcoins)0.10-1.00%
Futures (liquid)0.5-1 tick

Best Practices

  1. Always include costs: Never finalize a backtest with zero costs. Commissions + slippage + spread at minimum.

  2. Model the bid-ask spread: Buy at the ask, sell at the bid. If your data only has mid-prices, add half the typical spread as slippage.

  3. Account for market impact on larger orders:

Impact = k * sqrt(Order Size / Daily Volume)

Where k is typically 0.1-0.5 depending on the market.

  1. Use your actual broker’s fees: Look up the exact commission structure. Don’t guess.

  2. Run sensitivity analysis: Test with optimistic (half), base, and pessimistic (double) cost estimates. If the strategy is only profitable under optimistic costs, it’s too fragile.

Reducing Transaction Costs

  • Trade less frequently: Switching from daily to weekly rebalancing cuts costs ~80%.
  • Use limit orders: Avoid paying the spread (you earn it instead). Risk: not getting filled.
  • Trade liquid instruments: Prefer SPY over a small-cap ETF, EUR/USD over an exotic pair.
  • Size appropriately: Keep orders under 1-2% of average daily volume.
  • Choose a low-cost broker: Interactive Brokers charges $0.005/share vs. some brokers’ $4.95/trade.
  • Reduce turnover: Optimization that includes costs naturally favors lower-turnover strategies.

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