What Is Slippage And Why Does It Happen?

The currency market, like most financial markets, is a fast-moving one. Prices can vary from minute to minute, second to second—even in terms of milliseconds. That may bring pressure and headaches for traders, but in reality, it's often a good thing, because profits would never be made if prices remained static. Because of this reality, one particularly irksome fact of life for traders is slippage.

What Is Slippage?

Slippage is a real-world phenomenon where currency prices can change while an order is being placed, thus causing traders to enter or exit a trade at a price that's either higher or lower than they desired. This occurs on occasion because each price and trade size on a buy order must be matched with sell orders of equal price and size. Whenever there is an imbalance of buyers, sellers, prices and trade volumes, prices will need to shift and trade orders will need to be adjusted to the next available price.

For retail forex traders, it might be tempting to blame their brokers for not obtaining the desired price when slippage occurs. However, in a sense, slippage is verification for traders that they are operating in a real market environment and not an artificial one that could be manipulated by brokers and dealers.

Sometimes, when a market is less active and less liquid, the next available price will need to be offered not by another retail or institutional customer, but by a market maker. A market maker is a liquidity provider whose function is to make sure that the market operates smoothly and continuously even when there may not be enough other players in the market at a given moment to assure that price movements are fluid.^[1]

Can You Avoid Slippage?

Slippage may not be entirely avoided, but it can be reduced. One way for traders to cut down on the risk of experiencing slippage is to assure that their brokerage works with a number of liquidity providers. Another way for traders to dodge slippage is to try to avoid initiating trades during periods of high volatility. Volatile trading environments normally increase the chances for slippage as price moves at a faster pace and at wider intervals. To check volatility, traders may want to take recourse to analytical tools such as the average true range indicator or Bollinger Bands.^[2]

Market Range

Some brokers and dealers may also offer a "market range" feature on their order platforms that allows traders to select the amount of slippage they are willing to accept on a specific order. They may enter a range of several pips or zero pips. If the range of slippage accepted is not available, the trade won't be executed. Market range features often allow traders to specify only negative slippage. Thus, any positive slippage that goes in the trader's favour would still be allowed to occur.

How Much Slippage Is Acceptable?

Before offering their services, most dealers will notify traders in their terms and conditions that some slippage, also known as "execution risk," is possible and will exempt themselves from responsibility for losses. Therefore, each trader will need to decide how much risk he may be willing to run if unexpected slippage were to occur.

If traders believe that brokers are systematically introducing practices that provoke slippage, they may lodge complaints with agencies to request an investigation. Those include the Commodities Futures Trading Commission (CFTC) and the National Futures Association (NFA) in the U.S., and the Financial Conduct Authority (FCA) in the U.K.^[3]

Not Always A Bad Thing

Slippage is not always considered by traders to be a bad phenomenon. On occasion, it can occur in a trader's favour and actually widen the amount of profit he could make on a trade. That is another reason traders will want to carefully consider the amount of slippage they are willing to tolerate before entering a trade.

Summary

Slippage is a normal fact of life for currency traders that should be expected. It's particularly an issue in volatile trading environments where prices move quickly over a broad range. However, there are tools and strategies available that can help mitigate the problem presented by slippage. Traders should take these into consideration in order to minimise unnecessary losses in trading.