Whether you notice it or not, slippage is likely occurring in your investment portfolio. It happens when there is inadequate liquidity to complete an order at a desired price, so the broker fills the trade at the next best available level.
The phenomenon is simple, and happens when your expected price is different than the actual price paid or received. Yet the strategies utilized to avoid it require a little more effort to get a hold of, and slippage is frequently misunderstood.
In the forex market, like elsewhere, slippage occurs most during bouts of higher volatility because things are moving quicker than normal. It can also be the result of trade execution speed, as some broker platforms and client internet connections operate faster than others.
Regardless of the scenario, however, slippage can be either positive, negative or neutral.
There are always two sides to a trade, so the size of a buy order must be matched up with the corresponding numbers in sell orders. The imbalance causes a shift in market prices, so investors need to adjust.
If an investor wants to buy USD/JPY, for example, and more people want to sell the U.S. Dollar/Japanese Yen currency pair than there are buyers, there is a higher likelihood that the buyer gets a better-than-expected price (positive slippage). On the other hand, if there are few sellers and a lot of buyers, the chances of negative slippage will rise.
Since market orders involve buying or selling at current market prices, one way to avoid slippage is to use limit orders. Rather than executing a trade at the current (or spot) rate, this type of trade is requested at a specific price. If the security doesn’t hit that price, your broker won’t put the trade through.
Another strategy – in this case used to reduce the damage from a trade going wrong – is to utilize a stop loss order. By specifying with your broker the price at which a currency will be sold, it takes out much of the emotion or near-term pressure associated with the decision. The selling price is predetermined.
Large, more liquid currency pairs are less vulnerable to slippage. Since the USD/JPY, EUR/YEN, GBP/EUR and other majors are traded in much higher volume, they are likely to experience less volatility in a typical market environment. But that doesn’t mean they are immune to slippage, particularly during a busy cycle for financial news or amid major market-moving announcements, such as interest rate decisions and elections. Forex slippage is also more likely when currency pairs are trading outside of primary market hours, because markets have lower activity and liquidity.
Ensuring your broker has a large number of liquidity providers at its disposal also lowers the risk of slippage. Similarly, look for the “market range” feature when placing an order, as this will allow you to predetermine how much divergence from your price is permitted.
Slippage is part of playing the game and acts as proof that the market environment is real. While it cannot be avoided completely, particularly when entering and exiting positions rapidly, by understanding the associated risks and tools at your disposal, forex trading slippage can be your friend more often than not. Profits can’t be made if the market isn’t moving.