Slippery Slope: What is Slippage?
With the unfortunate demise of the prop firm My Forex Funds, the issue of slippage has recently become a hot topic. This educational post takes a look at the slippery issue of slippage, beginning with the basics all the way to addressing popular theories and speculations about slippage. Something to remember is that every trader, regardless of expertise, will encounter slippage during their trading activity.
What exactly is slippage?
Slippage is the term used in the forex market to describe the difference between the requested price at which you expect to fill your order and the actual price that you end up paying. Slippage most often occurs during periods of high market volatility, when market conditions are very thin due to low volumes traded or when the market gaps; all of these scenarios then lead to market conditions being such that orders cannot be executed at the price quoted. Therefore, when this happens, your order will be filled at the next available price, which may be either higher or lower than you had anticipated. Understanding how forex slippage occurs can enable a trader to minimise negative slippage while potentially maximising positive slippage.
Market Gap
High Market Volatility
Slippage is part of trading and cannot be avoided. This is due to forex market volatility and execution speeds. When a market experiences high volatility, it generally means there’s low liquidity. The reason for this is that during this time, market prices fluctuate very quickly. Where this affects forex traders is when there’s not enough FX liquidity to fill an order at the requested price. When this happens, the liquidity provider will complete the trade at the next best available price.
Another cause of slippage is execution speed. This is how fast your Electronic Communication Network (ECN) can complete a trade at your requested price. With market prices changing in fractions of a second, having faster execution times can make a difference, especially on large trades.
What is the difference between positive slippage, no slippage, and negative slippage?
When slippage occurs, it is usually negative, meaning you paid more for the asset than you wanted to, though at some times it can also be positive. When slippage is positive, it means you paid less for the trade than you expected and therefore got a better price. To get a better understanding of this, let's see the image below.
How do you calculate slippage?
Let's assume that the price of the EUR/USD is 1.05000. After doing your research and analysing the market, you speculate that it’s on an upward trend and long a one-standard lot trade at the current price of EUR/USD 1.05100, expecting to execute at the same price of 1.05100.
The market follows the trend; however, it goes past your execution price and up to 1.05105 very quickly—quicker than a second. Because your expected price of 1.05100 is not available in the market, you’re offered the next best available price. For the sake of the example, let's assume that the best next price is 1.05105. In this case, you would experience negative slippage (positive for the broker), as you got in at a worse price than you wanted:
1.05100 – 1.05105 = -0.00005, or -0.5 pips.
On the other hand, let’s say your trade was executed at 1.05095. You would then experience positive slippage (negative for the broker), as you got in at a cheaper price than you wanted:
1.05100 – 1.05095 = +0.00005, or +0.5 pips.
Negative Slippage Example
Is slippage a technical glitch in a broker’s software, or is it built and designed to bring in extra revenue?
There are popular beliefs that slippage is a software glitch or that it is made just to give brokers and liquidity providers extra revenue. This is not true, as slippage is something that is unavoidable. There are times when the markets are extremely volatile and price movements are too quick due to a lack of liquidity.
Slippage does bring in extra revenue for brokers and liquidity providers, but you need to remember that slippage goes both ways; while brokers and liquidity providers will generate profits from negative slippage, they will also generate losses from positive slippage. Though there are times when brokers (very rare) use price manipulation on their clients to generate additional revenue (more on this later).
How can a trader avoid or minimise slippage?
While slippage is impossible to fully avoid, there are a few things you can do to minimise the impact of slippage and protect yourself as much as possible in the markets, including using stop-loss orders to limit their exposure and placing orders during less volatile times.
Stop-loss orders are instructions to your broker to immediately exit a trade if it reaches a certain price. By using stop-loss orders, you can limit your losses if the market moves against you. High liquid markets such as Forex enable you to take advantage of market swings to enter and exit trades rapidly, limiting your exposure to the market but also increasing the risk that your stop-loss order may not be executed at the price you expect if the market moves quickly against you. Additionally, there are some brokers that offer traders guaranteed stop-loss orders called 'Guaranteed Stop Orders' (GSOs), meaning that the stop-loss price is guaranteed, which makes the trader unaffected by slippage when getting stopped out.
Another way to reduce the impact of slippage is to trade during less volatile times. The forex market is open 24 hours a day, but not all hours are equal. There are times when there are hardly any trading volumes being generated, and you want to avoid trading during this time at all costs as trading spreads will be wider and you will most likely get slipped due to the lack of liquidity in the markets. The best times to trade are usually when the market is most active, which is typically during specific trading sessions such as the Eurpoean or US trading sessions. To summarise, to minimise slippage, you should:
What is slippage tolerance, and how should you factor that into account with regard to your stop-loss and risk-to-reward calculations?
Some brokers will enable a feature called the 'Market Order Deviation Range' where the trader can adjust the slippage's maximum deviation. This is done so a trader can estimate his or her tolerance to slippage. For example, if you set the maximum deviation to 3 pips, the order will be filled as long as the slippage equals 3 or below. If the price slips beyond the set maximum, the order won't be filled. This is an effective way of managing your risk-to-reward calculations because if you have a strict risk-to-reward set-up and do not have much leeway to give in terms of slippage, you can adjust the slippage tolerance setting so that if the trade comes with more slippage than your trade can afford, it will not enter you in the trade.
How can a trader tell if his or her broker is being predatory with regard to slippage?
Although rare and illegal now that regulators are prevalent in the industry, in some cases, brokers may manipulate prices to cause slippage. This usually happens during times of high volatility when there are a lot of market orders. By creating a large amount of slippage, brokers can increase their profits. Forex brokers that are not regulated by the major governing bodies are more likely to do this. For a broker to gain the regulation of a major governing body, they must adhere to very strict guidelines set out by the regulating authority. Firstly, if you suspect that your broker is manipulating prices, you should immediately look for another broker. If you have evidence of your broker manipulating prices, you should report that broker to the financial authorities.
A good way to gauge if a broker is potentially manipulating prices is by requesting a trade journal from them. A good and reputable broker usually offers trade journals to their clients. Trade journals show execution times of trades and will have a comment on the journal if the trade was slipped. On a standard trade journal, slippage comments should not appear there often (unless you are trading at times when the market is volatile, thin, or trading outside liquid hours).
A broker that manipulates prices to their clients is usually hesitant to offer trade journals to their clients because it shows this on the trade journals. So if your broker is not willing to share the trade journals with you, you might want to think twice about continuing to trade with them. To add to that, you can also check if your broker is either a market maker or directly connected to the interbank market, as they will handle slippage differently.
To recap, slippage is a part of forex, and no trader is immune to getting it. It occurs most often during periods of high market volatility. Though slippage is almost impossible to avoid and can impact your profit and losses, there are a few things you can do to minimise slippage and its impact. This includes the use of limit and stop-loss orders, placing orders outside of volatile market times, avoiding major economic and news events, and only using brokers that are regulated by the major governing bodies.
BluetonaFX
