Last Updated on 31 March, 2021 by Samuelsson
Trading is not an easy job, no matter how well you prepare yourself. There is always something that will try to knock you off your game, and one of them is slippage. Whether you are trading stocks, Forex, or futures, slippage inevitably happens. But what exactly is slippage?
Slippage is what happens when your market entry or exit order is filled at a price different from the one you had intended. It refers to the difference between the expected price of a trade and the price at which the trade is executed. While slippage can occur at any time, it is most likely to happen when there is high volatility in the market.
In this post, you will learn the following:
- What slippage means in trading
- How it is calculated
- Its effects on your trading
- How to stop or minimize slippage
- What you should know about slippage warning
What is slippage in trading?
In financial trading, slippage is a term that describes what happens when a market order is filled at a different price from the intended price. Numerically, slippage refers to the difference between the expected price of a trade and the actual price at which the trade is executed.
This phenomenon occurs when you place market orders during periods of elevated volatility. It also occurs when large orders are placed at a time when there is insufficient opposite interest in an asset to absorb the orders. In other words, there isn’t enough volume at the chosen price to maintain the current bid/ask spread.
Slippage normally happens during high periods of volatility because orders cannot be matched at desired prices due to the fast pace of price movements in the financial markets at such periods. Hence, there is a higher chance of slippage may occur due to the delay that exists between the point of placing an order and the time it is completed.
Slippage can occur in any market — stock, Forex, and futures — and the explanation is similar for those markets. So, the term is used by both Forex and stock traders to express the same phenomenon whereby orders are executed at a different price than the intended price.
To put it all together, slippage refers to situations in which a market participant receives a different trade execution price than intended, and it occurs when the bid/ask spread changes between the time a market order is requested and the time an exchange or other market makers execute the order. As you would expect, slippage occurs in all markets, including equities, bonds, currencies, and futures.
How does slippage work?
Some people tend to think that slippage only denotes a negative effect — getting your orders filled at a worse price than you intended. However, slippage does not really denote any specific price movement — whether negative or positive. Any difference between the intended execution price and the actual execution price qualifies as slippage. So, slippage can be favorable or unfavorable to the trader.
Here is how it works: Anytime a buy or sell order is placed, the order is executed at the best available price offered on an exchange or by a market maker, which can produce results that are equal to, more favorable, or less favorable than the intended execution price. Thus, considering the actual execution price vs. the intended execution price, the order execution can be categorized as no slippage, positive slippage, or negative slippage.
As market prices can change quickly, slippage can occur during the delay between when a trade is ordered and when it is executed. Slippages occur with market orders or pending orders, such as stop orders (including stop loss orders), which are executed as market orders when the price reaches the set level.
A limit order prevents negative slippage, but it carries the inherent risk of the trade not being executed if the price does not return to the limit level. This is more likely to happen in situations where market fluctuations occur more quickly, which limits the amount of time for a trade to be completed at the intended execution price.
Examples of slippage
As we stated above, order execution can be at the intended price (no slippage), worse than the intended price (negative slippage), or better than the intended price (positive slippage). Let’s take a look at those examples:
- No slippage: Let’s say you want to buy Twitter stock, and the bid/ask prices are quoted as $65.50/$65.54 on the broker’s platform. You place a market buy order for 200 shares, and the order gets filled at $65.54, which is the ask price you intended to buy at. So, there is no slippage in this case.
- Negative slippage: Let’s assume that the Twitter stock, which was quoted as $65.50/$65.54 on the broker’s platform, was filled for your buy market order at $65.95. In this case, the buy order was filled at a worse price than intended. So, there was negative slippage of $0.41.
- Positive slippage: In this case, you place your buy market order, expecting it to fill at $65.54 as was quoted on the broker’s platform ($65.50/$65.54), but the order was filled at a lower price, say $65.41. So, you have a positive slippage of $0.13. Interestingly, if the price came up again to around the price quote you saw earlier, you are invariably in profit early on.
Why does slippage occur?
Now, we know what slippage is and have seen some examples, but why does it occur in trading?
One of the main reasons that slippage occurs is the abrupt change in the bid/ask prices as the orders in the market are taken out. So, any market order that comes in may be executed at a less or more favorable price than originally intended. If the ask has moved higher in a long trade by the time the order is filled or the bid has moved lower in a short trade, negative slippage occurs. On the other hand, if the ask price moved lower in a long trade when the order is filled or the bid moved higher in a short trade, positive slippage occurs.
To understand why the bid/ask prices changes, you need to understand how price quotes come about and how market orders are filled in the market. For the most part, the ask and bid prices that are quoted by an exchange are from sell limit and buy limit orders placed by traders or market makers. The ask price is the lowest sell limit order in the market at any given moment, while the bid price is the highest buy limit order in the market at that moment.
As market orders flow into the market, they take out the current bid/ask prices — buy orders take out the ask price, while sell orders take out the bid price — and a new set of bid/ask prices emerge. During periods of high volatility in the market, due to the fast-paced market activity and the enormous volume of market orders that flood the market, the bid/ask price quotes changes very fast such that before your placed order reaches the market to be executed, the price quotes have changed, which can be favorable or unfavorable.
Something similar happens in a market with low liquidity, which is also another cause of slippage. In this situation, there are few limit orders in wait in the market, so the bid and ask prices may be wide apart, leading to a wide spread. Since there are few opposite orders in the market to absorb your own orders, some of your orders may be filled at the quoted bid/ask price, while others may be filled at the next best available price.
Interestingly, you can protect yourself from slippage by placing limit orders and avoiding market orders. However, your limit orders might not get filled.
How do you calculate slippage?
Simply put, slippage is the difference between the actual execution price and the expected entry price.
Slippage = Expected Entry Price — Actual Execution Price
However, depending on your order size, the entry price may not be at one price level. If your order size is more than the opposite orders quoted at that price level, the rest of your orders will be filled at the next price level. In effect, your actual execution price will be an average of those prices at which your orders were executed. So, it’s best to use the average execution price and be given as:
Slippage = Expected Entry Price — Average Execution Price
Slippage can be measured in ticks, points, dollars, etc.; however, it can also be measured as a percentage of the range of the price bar since the worst possible slippage would occur by buying at the high of the bar or selling at the low of the bar, which would represent 100% slippage on the order.
Slippage percentage is calculated by dividing the numerical slippage by the difference between the expected entry price and the worst possible fill price (the price bar’s high for a long position or low for a short position).
Let’s see an example using a “buy” order in Twitter stock:
Expected Entry Price: $65.54
Average Execution Price: $65.95
Price bar high (worst possible long entry price): $66.55
Slippage = $65.54 — $65.95 = -$0.41
The worst case scenario = $65.54 — $66.55 = -$1.01
Slippage percentage = (-$0.41/$1.01) x 100 = 40.6%
The effects of slippage in trading
Most system-based traders tend to focus on the core of their strategies — entry and exit order logic — and forget about slippage, which is an important but often-neglected factor in system development, backtesting, and live trading is slippage. In fact, slippage alone can break an otherwise profitable trading system.
Since most momentum strategies, such as trend-following, get in and out of positions in the direction of the price momentum, they are particularly susceptible to the negative effects of slippage. Negative slippage can reduce the profitability of a trading system, and here is how:
In a situation where the profit target is already set at a specific price level, negative slippage reduces the amount of profit obtainable from that trade. Apart from that, if the system is based on a specific profit size to exit a profitable trade, negative slippage could make it difficult to achieve that profit size before the price turns in the opposite direction and stops out a trade that would have been a profitable one if there was no slippage.
How can we stop or minimize slippage in trading?
The only way to ensure that you don’t get slippage is by using only limit orders, even for your stop loss orders — stop limit order. However, you will endure the risk that your limit order may not be triggered. So, your orders may not get filled, and that may deny you an opportunity to make money or even lead to losing trades.
On the other hand, you can minimize slippage by doing any of these:
- Trade in low volatile and high liquidity markets: In low volatile markets, price quotes don’t usually change quickly; highly volatile markets, on the other hand, have many market participants on the other side of the trade. Hence, if you trade in highly liquid and low volatile markets, you can limit the risk of experiencing slippage. Trade during the most active period in whatever market you are trading.
- Understand how your broker and the exchange treat slippage: Some providers will execute the orders even if the price does not match the requested price, but others will allow you to specify your slippage tolerance level and execute your order only if the price difference is within your tolerance level. If the price difference falls outside the tolerance level, your trade order will be rejected, and you will have to resubmit the order at a new price.
What is a slippage warning?
These days, some brokerage platforms and cryptocurrency exchanges now include a slippage warning when the condition in the market is such that your order can experience a significant slippage if placed at that time. The warning often carries a specific cut-off point, like 2% or 3%. For example, Coinbase, a popular cryptocurrency exchange, gives a slippage warning that tells you whether your order would experience greater than 2% slippage if executed at that time.