What Is an Implementation Shortfall?
In trading terms, an implementation shortfall is the difference between the prevailing price or value when a buy or sell decision is made with regard to a security and the final execution price or value after taking into consideration all commissions, fees, and taxes.
As such, implementation shortfall is the sum of execution costs and the opportunity cost incurred in case of adverse market movement between the time of the trading decision and order execution, and is a form of slippage.
- Implementation shortfall is when a market participant receives a different net execution price than intended on a trade.
- This is due to the time lag between making a trade decision and implementing it through one or more orders in the market.
- Market orders are most prone to implementation shortfall, while limits and stops can reduce getting filled at an unfavorable price; however, a limit order does not guarantee a fill if the market moves against you.
Implementation Shortfalls Explained
In order to maximize the potential for profit, investors aim to keep implementation shortfall as low as possible. Investors have been helped in this endeavor over the past two decades by developments such as discount brokerages, online trading, and access to real-time quotes and information.
Implementation shortfall is an inevitable aspect of trading, whether it be stocks, forex, or futures. Slippage is when you get a different price than expected on an entry or exit from a trade. Using the correct type of orders (e.g. limits or stops) can help reduce the implementation shortfall, as can relying on high-speed algorithmic trading systems to automate decisions and executions.
Example of an Implementation Shortfall
If the bid-ask spread in a stock is $49.36/$49.37, and a trader places a market order to buy 500 shares, the trader may expect it to fill at $49.37. However, in the fraction of a second it takes for your order to reach the exchange, something may change or perhaps the traders's quote is slightly delayed. The price the trader actually gets may be $49.40. The $0.03 difference between their expected price of $49.37 and the $49.40 price they actually end up buying at is the implementation shortfall.
Order Types and Implementation Shortfalls
Implementation shortfalls often occur when a trader uses market orders to buy or sell a position. To help eliminate or reduce it, traders use limit orders instead of market orders. A limit order only fills at the price you want, or better. Unlike a market order, it won't fill at a worse price. Using a limit order is an easy way to avoid implementation shortfall, but it's not always the best option.
When entering a position, traders will often use limit orders and stop limit orders. With these order types, if you can't get the price you want, then you simply don't trade. Sometimes using a limit order will result in missing a lucrative opportunity, but such risks are often offset by avoiding implementation shortfall. A market order assures you get into the trade, but there is a possibility you will do so at a higher price than expected. Traders should plan their trades, so they can use limit or stop limit orders to enter positions.
When exiting a position, a trader typically has less control than when entering a trade. Thus, it may be necessary to use market orders to get out of a position quickly if the market is in a volatile mood. Limit orders should be used in more favorable conditions.