Slippage is the term we use to describe the difference between the expected price of a
trade and the real figure at which it was executed.
To create a market there are two groups of active traders: The buyers and the sellers. The list of all buyers and sellers is called the Order Book. The sellers line in the ask side while the buyers in the bid side.
The distance between the lowest bid price and the highest ask price is called the spread. When one trader crosses the distance and accepts the price of the other side a trade is executed.
Figure 1: Graph of the Order Book showing the spread.
How does slippage happen?
The market is in constant movement and there is a small lag between when the trader orders a trade on his trading station and the moment it enters the market. During this time lapse, the price could have moved in his favour, stay still or moved against him.
If a trade is executed at the expected value it is said that its slippage is zero. If the trade executes at a better price than intended the resulting slippage is negative. If the trade executes at a worse price than expected by the order the resulting slippage is positive.
Why does slippage change?
There are two main causes why slippage tightens or moves apart. The first cause is liquidity and the second is volatility.
Liquidity is what traders call to the amount or active orders in the Order Book. If the Order Book is full of orders the asset is said to be highly liquid. If, on the contrary, the Order only shows a few interested traders, we say the asset lacks liquidity.
Lack of liquidity usually creates wide spreads, and slippage worsens when spreads widen. Conversely, high liquidity is the best cure for wide spreads. Also, high liquidity means that the price takes longer to move because the price can withstand more and large orders. Therefore, slippage is minimised when the trades are taken on highly liquid pairs or assets.
Volatility is the condition that is linked to the uncertainty of the price. It is the noise of the market. A highly volatile asset means it is highly likely that the price jumps from one price to another one at a large distance. If the volatility shrinks the price gets constrained into a tighter range, reducing the probability of large price swings.
As seems obvious, slippage becomes larger in the presence of high volatility. The likelihood of a higher slippage increases when volatility grows, because the market accelerates and the price moves faster and with large swings.
Slippage happens with a type of order called “Market order”. A Market Order is the type of order enters at whatever price is at the moment. It will take the best ask price of the Order book if it is a Buy Market order or the best bid price if it is a Sell Marker order.
The good thing about market orders is that the trader has a guarantee that it will get filled. The dark side of it is that the price may suffer a positive slippage. This especially so, under the conditions of high market volatility, as expressed early on.
A Limit Order is an order to buy or sell at a price set by the “limit” level condition.
The good side of this type of order is that the trader has the guarantee that the order will be filled at the limit price. The “dark” side of the limit order is that there is no guarantee that the market will move to the price level needed to fill the order.
Graph 2 – Schema of a limit order.
Limit orders can be set at the current price also. The figure just illustrates the concept that the market has the move op or down to touch the limit before it gets filled. If the level set by the order matches the current market level it gets immediately filled.
Protection against Slippage:
The best strategy to protect against slippage is to have the trade plan totally defined. If that is the case, the trader will know at which level the entry order should be executed.
With Entries usually there are two cases: The trader is waiting for a pullback or waiting for a breakout.
Pullbacks can be caught with a limit order at the desired level, below the market when it is a long position or above the market if it is a short position.
breakouts usually are taken using a stop order. Stop orders are orders that get executed only when the stop level is touched. The downside of this is that when that level is reached the stop order becomes a market order. That guarantees the execution of the order but not the price.
There is another order type called Stop Limit Order that overcomes this problem by converting this order into a limit order once the stop level is hit. That way the trader can be protected against slippage but with no guarantee of its execution.
Once in a trade, to exit and protect profits the trader should send a Limit Order at the price set by the “take profit” level defined by his strategy.
Stop-loss orders are set to protect the capital against unexpected events, therefore they should be Stop Orders (not Stop Limit Orders). That way we guarantee its execution, although, at the expense of some slippage. But. capital protection should be our first goal when the trade goes against us.
The worst time to enter an order is when volatility spikes. This happens mostly with unexpected events that shatter the market but also when a scheduled economic release publish surprising figures that change the perception and sentiment of the traders.
Thus, it is very important to keep track of important events using economic calendars publicly available on the internet and stop trading (also closing open positions) ten or fifteen minutes before such economic data is released.
Further recommended reading:
Credit for The Order Book graph: taken from the Kraken On-line Trading App.