What is Slippage?
Slippage is defined as the difference between the expected price and the actual execution price. It often occurs during periods of high volatility and when large orders are executed, where there isn't enough volume to maintain the bid-ask spread at the time the order is filled.
How Does Slippage Occur?
In any market and for any financial asset, when traders place an order, the transaction is executed at the best price offered by the market maker. There is a delay between the time a trader enters an order and when the order is executed. This delay may be longer for some market makers, while it is as short as milliseconds for others. Regardless of the execution time, especially during periods of high volatility or when high-volume orders are entered, the price at which the order is placed can differ from the price at which it is executed. This is referred to as slippage.
Slippage can be either positive or negative. In long positions, if the execution price is higher than the order price, it is called negative slippage, and if it is lower, it is called positive slippage. For a trader entering a long position, the lower the entry price, the better. Entering a long position at a higher price due to slippage means missing out on potential profit.
Conversely, in short positions, execution above the order price is positive slippage, and below is negative slippage. For short positions, the higher the positive slippage, the more additional profit opportunity for the trader. Negative slippage reduces the trader's potential profit.
For example, suppose a trader wants to open a long position while the ask and bid prices for GOLD are 2316.21/2316.41. Although the trader enters a market order at 2316.41, the price continues to move until the order is executed at the best price available at that moment. If the execution price is 2316.52, it is negative slippage; if it is 2316.38, it is positive slippage.
Moreover, slippage most significantly affects traders when closing open positions. Continuing the above example, suppose a trader opened a 1 lot long position at 2316.41 and wants to exit at 2321.41 for a $500 profit. If, at the moment the trader places the closing order at 2321.41, prices continue to move and the best price available when the order is executed drops to 2321.21, the position closes with a $480 profit. The trader has experienced negative slippage, leading to a $20 deviation from the targeted profit. Conversely, if the best price rises to 2321.57 by the time the order is executed, the position closes with a $516 profit. In this case, the trader benefits from positive slippage and gets $16 more than targeted.
How to Avoid Slippage
Slippage typically occurs due to increased volatility following data flows or significant developments. Traders who wish to avoid exposure to slippage can protect themselves by not taking positions immediately following these flows.
Slippage is frequent in assets with insufficient liquidity. Traders must be cautious of slippage, especially when trading assets with low liquidity. These markets are shallow, and even orders without very high volumes can significantly move prices.
On the other hand, even the most liquid assets known as majors can have fluctuating liquidity. The Forex market is open 24/5, but not every hour sees the same volume of transactions. The highest trading volumes generally occur during the overlapping hours of the London and New York sessions. High liquidity reduces the risk of slippage.
Additionally, traders can use limit orders to protect against slippage. Market orders are executed at the best price available at the moment the order is entered. However, in situations with sudden price changes, the best market price can be different from our desired price. Limit orders, on the other hand, are executed only at a specified price or better, thus eliminating the risk of negative slippage.
Conclusion
Slippage is inherent in financial markets, and every trader faces it. Understanding slippage, managing it, and incorporating it into trading strategies is critical for successful trading.