Spread and slippage don’t matter in backtests? is a common misconception that can lead to unrealistic expectations when testing a trading strategy. While backtesting provides valuable insights into a strategy’s potential performance, it’s important to remember that real-world trading involves transaction costs like spread and slippage, which can significantly impact the results. Ignoring these factors in backtesting can lead to overly optimistic assumptions about the viability of a strategy. This article explores why spread and slippage should be considered during backtests and how including them can improve the accuracy and reliability of your strategy testing.

What is Spread and Slippage?

Before understanding why spread and slippage matter, let’s define what they are:

1. Spread
The spread is the difference between the buying (ask) price and the selling (bid) price of a currency pair or asset. It’s the cost that traders pay for executing a trade. The spread is typically wider for less liquid assets and narrower for more liquid ones like major currency pairs. For example, if the EUR/USD spread is 1 pip, the price at which you can buy is 1 pip higher than the price at which you can sell.

2. Slippage
Slippage occurs when the execution price of an order is different from the expected price, especially in volatile market conditions. It can happen during high-impact news events, when liquidity is low, or during sudden price movements. For instance, if you place a stop-loss order at a certain price but it gets executed at a worse price, the difference is called slippage.

Why Spread and Slippage Matter in Backtests

1. Real-World Costs Affect Profitability
Backtesting without factoring in spreads and slippage can lead to inflated profit results. While you may see a strategy that appears to have great returns in a backtest, those results don’t reflect the true costs of executing trades in a live market. The spread reduces the amount you can profit from each trade, and slippage can add to the difference between your expected and actual trade results. These factors are critical for understanding the true profitability of a strategy.

For example, if your strategy yields 50 pips of profit per trade, but your broker’s spread is 2 pips, your net profit per trade would be 48 pips. If slippage occurs, the actual profit could be even less, impacting the overall performance.

2. Spread Can Impact Entry and Exit Points
The spread is a transaction cost that affects your entry and exit points. If you backtest a strategy without considering the spread, you may find that your trade entries occur at prices that are actually worse in a live market. This could lead to missed profit opportunities or unanticipated losses, as your strategy is not accounting for the difference between the bid and ask prices.

For example, you may backtest a strategy that signals an entry point when the price is at 1.2000, but after accounting for the spread, the actual entry price might be 1.2002 (if the spread is 2 pips). This small discrepancy can accumulate over time, reducing your overall profitability.

3. Slippage Affects Execution During Volatile Conditions
Slippage can have a significant impact during volatile market conditions or when there is low liquidity. Backtests that ignore slippage don’t capture these realities, leading to unrealistic expectations of how the strategy would perform under real trading conditions. Slippage is more likely to occur during high-impact news events, when price moves rapidly, or during times of low market liquidity. By not factoring in slippage, your backtest results may be overly optimistic, as they fail to consider these unpredictable events.

For instance, if you place a market order during a news release, the price might move sharply, and your order could be filled at a price much worse than expected. This slippage can lead to losses or reduced profits, which wouldn’t be evident in a backtest that ignores slippage.

4. Slippage and Spread Can Impact Risk/Reward Ratios
If you’re relying on tight risk/reward ratios in your strategy, slippage and spread can affect how often you hit your stop-loss or take-profit targets. In backtests, you may have the ideal risk/reward ratio of 1:2, but in real trading, slippage and spreads can cause your stop-loss to be triggered more frequently, or your take-profit to be missed, reducing your effective risk/reward ratio.

For example, a trade with a stop-loss of 20 pips and a take-profit of 40 pips might look good in a backtest. But if slippage causes you to exit the trade at a worse price, you may only end up making 30 pips in profit instead of 40, thus altering your intended risk/reward ratio.

How to Account for Spread and Slippage in Backtesting

To make your backtests more accurate and reflective of real-world trading conditions, it’s crucial to account for both spread and slippage. Here’s how you can incorporate them into your backtesting process:

1. Include Spread in Your Backtest Settings
Most backtesting platforms (such as MetaTrader, TradingView, and others) allow you to account for the spread. When setting up your backtest, include the spread cost as part of your strategy parameters. This ensures that each trade’s entry and exit points reflect the real costs of executing trades in a live market. If your broker has a variable spread, be sure to set it to match the conditions during the time of day or in the market you’re testing.

2. Simulate Slippage
Some backtesting platforms also allow you to simulate slippage by adjusting the execution price of orders. You can set slippage to occur based on market conditions, such as during volatile periods or news events. For a more realistic backtest, consider setting a default slippage value (e.g., 1 or 2 pips) for every trade, or apply slippage only during high-volatility periods.

3. Use Realistic Execution Models
When conducting backtests, it’s important to use an execution model that reflects the type of trading environment you’ll be in. If you’re trading with a market-maker broker (where spreads are typically higher), your backtest should reflect those conditions. Similarly, if you trade with an ECN broker (where spreads are tighter but you pay commissions), ensure that your backtest accounts for the commission and tighter spreads.

4. Test in Different Market Conditions
To see how spread and slippage impact your strategy, test it under different market conditions. Run backtests during periods of high volatility, such as during major news releases or economic events, to evaluate how your strategy performs when slippage is more likely. This can give you a better understanding of how your strategy holds up in real-market conditions.

Conclusion

Spread and slippage don’t matter in backtests? This is a misconception that can lead to unrealistic expectations of a strategy’s performance. Both spread and slippage are critical factors in real-world trading and can significantly affect your profitability. Ignoring them in backtests can result in overly optimistic outcomes and a false sense of security. To improve the accuracy of your backtests, make sure to incorporate realistic spread and slippage values, and test your strategy under various market conditions. By doing so, you’ll gain a more accurate understanding of how your strategy will perform in live markets, helping you make better decisions when it comes to risk management and trade execution.

Learn how to properly backtest your strategies, account for spread and slippage, and refine your trading techniques with our expert-led Trading Courses designed for traders focused on long-term success and profitability.