Understanding Slippage in Finance: Key Insights and Examples

Slippage refers to the difference between the expected price of a trade and the price at which the trade is executed. Slippage can occur at any time, but it is most prevalent during periods of higher volatility when market orders are used. It can also occur when a large order is executed, but there isn't enough volume at the chosen price to maintain the current bid/ask spread.

Slippage can be positive or negative. Positive slippage means the investor gets a better price than expected, while negative slippage means the opposite. It's important for investors to understand slippage to make informed trading decisions. There are methods to mitigate slippage, such as using limit orders or choosing calm market times.

Understanding the Mechanics of Slippage

Slippage does not denote a negative or positive movement because any difference between the intended execution price and actual execution price qualifies as slippage. When an order is executed, the security is purchased or sold at the most favorable price offered by an exchange or other market maker. This can produce results that are more favorable, equal to, or less favorable than the intended execution price. The execution price can result in positive, no, or negative slippage compared to the intended price.

Market prices can change quickly, allowing slippage to occur during the delay between a trade being ordered and when it is completed. The term is used in many market venues, but definitions are identical. However, slippage tends to occur in different circumstances for each venue.

A limit order prevents negative slippage but risks not being executed if prices don't reach the limit. This risk increases in situations where market fluctuations occur more quickly, significantly limiting the amount of time for a trade to be completed at the intended execution price.

Example of Slippage in Trading

One of the more common ways that slippage occurs is as a result of an abrupt change in the bid/ask spread. A market order may get executed at a less favorable or more favorable price than originally intended when this happens.

With negative slippage, the ask has increased in a long trade or the bid has decreased in a short trade. With positive slippage, the ask has decreased in a long trade or the bid has increased in a short trade. Traders can avoid slippage by using limit orders instead of market orders.

For example, say Apple's bid/ask prices are posted as $183.50/$183.53 on the broker interface. A market order for 100 shares is placed, with the intention that the order gets filled at $183.53. However, microsecond transactions by computerized programs lift the bid/ask spread to $183.54/$183.57 before the order is filled. The order is then filled at $183.57, incurring $0.04 per share or $4.00 per 100 shares, which is negative slippage.

 Exploring Slippage in the Forex Market

Forex slippage occurs when a market order is executed, or a stop loss closes the position at a different rate than set in the order. Many traders and investors use stop-loss orders to limit potential loss. An alternative approach is to use option contracts to limit your exposure to downside losses during fast-moving and consolidating markets.

Forex slippage is more common during high volatility from events or when trading outside peak hours. In both situations, reputable forex dealers will execute the trade at the next best price.

Strategies for Minimizing Slippage Impact

Slippage is a part of investing, although there are some ways to avoid it or limit its impact.  Slippage often happens in volatile or low-liquidity markets, so timing and security type matter.

Trade in Calm Moments

The less volatility in the market, the less chance you have of getting caught out by slippage. If you want to limit slippage, don't invest around the time of major economic announcements or important updates relating to a security you wish to trade, such as an earnings report. These types of events can move markets significantly and lead prices to jump around.

Place Limit Orders Instead

Market orders execute quickly, while limit orders only go through at a set price or better. If you place a limit order, you can avoid negative slippage. However, there is also the risk that the order doesn’t get executed.

The Bottom Line

Slippage is the discrepancy between the intended and actual execution price of a trade. It can occur in any market venue such as equities, bonds, currencies, and futures, and is prevalent in volatile or illiquid markets. Slippage can be reduced by trading in liquid and stable markets. It can also benefit investors.

Slippage can be positive, negative, or neutral: positive slippage benefits the investor by providing a better price, whereas negative slippage is disadvantageous. Ways to mitigate slippage include trading in calm markets, using limit orders, and understanding market conditions to avoid volatile times. While slippage is a common experience in trading, knowledge and strategic order placement can help investors manage its impact effectively.