Understanding the Concept of Slippage in Trading

Understanding the Concept of Slippage in Trading

Slippage is a term used in trading to identify when the price that you requested to execute your order is not matched, meaning that you either end up filling your order at a higher or lower price. It happens most frequently with illiquid and fast-moving markets.

In this article, we will outline what slippage is, the different types of slippage, what causes slippage and how traders can avoid it.

What is slippage in trading?

Slippage in trading refers specifically to the difference between the expected price of a trade and the actual price of execution. This can work both ways, with either a stop loss occurring later than expected, or an order being filled later than expected.

(Negative slippage)

When an order is created, it is essentially a signal to the market that you are willing to either buy or sell a security at a specific price. This notification that you want to sell then needs to be ‘filled’, which means in simple terms that another buyer or seller needs to be found.

If you are trading in a market with high liquidity and low volatility, and with a market maker, then it is likely a buyer or seller will be found instantly and your order will be filled at your agreed price. However, this depends on the efficiency of the market. 

If there is any disruption in the markets or with the liquidity providers, then the trade will be delayed as a buyer or seller in the conventional sense is yet to be found. In fast-moving markets, even a delay of a few seconds can change the price and affect the trade.

Positive & negative slippage

Slippage is not necessarily negative. It can work in a trader’s favour too. Most honest brokers allow positive slippage, as well as negative. It is worth noting that FXCM produce monthly statistics on the slippage experieced by their clients including positive slippage (otherwise known as "Price Improvement") whereby a client experiences an inmprovement either by a higher selling price, or a lower buying price. See their monthly statistics here. 

For example, if a trader sets a take profit at a certain price on a security that is skyrocketing and there is slippage, the price at which the security is sold will be higher than intended and the trader will take even more profits.

Negative slippage is when the price ends up worse than intended, either a higher price paid for a long position or a lower expected price for a short position. Positive slippage will be the opposite.

Most honest brokers allow positive slippage, as well as negative. It is worth noting that FXCM produce monthly statistics on the slippage experieced by their clients including positive slippage (otherwise known as "Price Improvement") whereby a client experiences an inmprovement either by a higher selling price, or a lower buying price. See their monthly statistics here. 

As part of their quality of execution transparency, FXCM also are very transparent about their execution venues and against which of their Market making Liquidity Providers their client orders get executed. See the Top 5 Execution venues for FXCM here. (We do not know of any other broker that is this transparent - please let us know of others in the comments below, if there are any!)

What causes slippage?

The causes of slippage are complex and often opaque. In fast-moving and popular markets, even though a trade may happen in seconds, it will need to go through many financial bodies and processes to be filled.

In this example, we will be using a retail forex trade, and identifying where slippage can occur.

1. Trade initiation

A trader will decide to sell a particular currency pair, such as EUR/USD. The trader places an order via their chosen trading platform or method.

This platform will route the order to a market maker, which could be via an ECN (Electronic Communication Network) or another liquidity provider.

2. Order matching

The liquidity provider, or market maker, will receive the order and then generate a quote for the order, which will be based on the conditions of the market. This method of using a market maker is beneficial as it helps to find a buyer or seller rapidly and also helps the liquidity of the market and maintains a stable bid-ask spread.

Using the quote, the market maker can choose to either match the order, if there is a willing buyer in this case, or choose to take the order itself.

3. Trade execution

Once a willing buyer has been found, or the market maker has filled the order, the order is executed at the agreed price. This information is then fed back to the user.

Where slippage occurs

It is in the order-matching process where slippage occurs. A fast-moving market means that the order matching process must be instant, or at least near-instant, otherwise the price the trader requested can be different to the one they receive.

Delays in this process, information distortion and market maker activity can contribute to slippage – for example, market makers choosing to implement last look. 

Last look & slippage

Last look is a method of trading by market makers whereby they will look to fill the trade, but if they can’t, they will reject the order.

From a market maker’s perspective, it means they can manage risk for trades in fast-moving markets and ensure they are always getting the best price for their trades.

However, critics argue that market makers use last look purely to generate more profits, and in turn, disrupt the markets by creating more slippage. Furthermore, if multiple liquidity providers are implementing last look, a trade could theoretically be rejected more than once, creating even more slippage.

Ethically, it is also unfair to traders, as market makers are rejecting the trade based on price movements that happen after the order is placed but before it is executed. A trader could have made a well-informed and profitable trade, but due to how the market maker behaved after they placed the order, the trade was not executed as promised.

David Mercer, CEO of LMAX group referred to pre-trade hedging and last look as “abuses in the marketplace”.

Other causes of slippage

Slippage can occur for many other reasons, and often a combination of factors. Large order sizes can be a factor in less liquid markets, as if there isn’t enough volume at the required price level, a buyer or seller may be difficult to find, and market makers might not be willing to accept the trade. 

Traders placing market orders may also be more prone to slippage, as the best available price can change rapidly. Technology can be a factor too, and if there is network latency or inefficient trading platforms involved, these can contribute to slippage. 

What FX brokers can do to avoid slippage

There are many methods that a trader can use to avoid slippage in trading. While slippage is still an issue, there are measures that can be taken to protect certain trading strategies.

Limit orders

Limit orders are one way to avoid negative slippage. By putting a restriction on the maximum price to be paid or the minimum price to be received, an order can be protected as it will only be filled within this price range (or better if there is positive slippage).

Trading times & style

Trading during periods of high activity can help to reduce slippage. If you are trading a major pair at a peak time, such as the overlap of major trading sessions, then it is less likely that slippage will occur as there will likely always be a buyer or a seller at your requested price, and market makers will have no need for last look.

Traders can also benefit from breaking up large orders into multiple small orders. This way, less liquidity is needed for one single trade and is then spread out. Therefore your risk of slippage is reduced, as if it does happen, it may only occur on a few of the trades.

Fill or Kill (FOK) orders

Avoiding slippage can also be done by putting in Fill or Kill (FOK) orders. An FOK order is a specific type of order that states an order must be filled in its entirety, or it will be cancelled.

It ensures that a trader does not receive partial fulfilment – it must either be fully filled immediately or not at all. This is an ideal method for avoiding slippage as it means a trader will not accept a lower price than their order. 

Similar to an FOK order is an All or None (AON) order. AON orders are where a trader will make an order that must be fully executed or it will stay open. Unlike an FOK order, an AON order will remain active until the order is executed at the desired price.

Conclusion

Slippage is an issue for large parts of the financial market and is often caused by questionable practices from market makers and inefficiencies in the system. Fortunately, there are methods that traders can implement to reduce slippage and ensure that their trades are being executed at the right price.

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Author

Caleb is a financial copywriter with a specialisation in fintech and forex. Former copywriter at Barclays and Paysafe. Contributing writer for LiquidityFinder. You can message Caleb here.