SLIPPAGE IN TRADING: WHAT IT MEANS AND HOW TO REDUCE IT

What is Slippage in Trading?

Slippage in trading occurs when an order is executed at a price different from the one expected by the trader. It's a common phenomenon in both forex and stock markets, particularly during periods of high volatility or low liquidity. Slippage can be either positive or negative depending on the direction of price movement against the expected price.

For example, if a trader sets a buy order at £100 for a stock, but the order is executed at £101 due to rapid price changes, the slippage is -£1. Conversely, if the order is filled at £99, the slippage is positive, and the trader benefits. Either way, the execution price deviates from the initial expectation.

Why Does Slippage Occur?

Slippage primarily arises for three reasons:

• Market Volatility: Rapid price fluctuations during news events or economic disclosures can lead to delays in order execution and pricing discrepancies.
• Liquidity Constraints: If there aren’t enough buyers or sellers at the desired price level, the order moves to the next best available price, causing slippage.
• Order Type Used: Market orders are more prone to slippage because they prioritise speed over price. Limit orders, meanwhile, reduce slippage but carry the risk of non-execution.

Types of Slippage

There are two primary types of slippage:

• Positive Slippage: When the trade is executed at a better price than anticipated. For example, a buy order filled at a price lower than expected.
• Negative Slippage: When the price received is worse than expected, leading to higher costs for buys or lower gains for sells.

Which Markets Are Most Affected?

Slippage is more common in markets with rapid price changes or lower liquidity. These include:

• Foreign Exchange (Forex): Slippage is frequent due to the global nature and constant trading activity in forex markets.
• Equities: Particularly mid- to small-cap stocks with lower volume can exhibit higher slippage.
• Cryptocurrencies: These volatile assets often come with erratic price movements and limited liquidity on certain exchanges.

Understanding the market and trading conditions are key in anticipating potential slippage events.

How Is Slippage Measured?

Slippage is measured by calculating the difference between the intended execution price and the actual fill price. This can be expressed in points, pips (in forex), or simply in monetary terms. Brokers sometimes provide slippage reports or show the executed price versus the requested price in trade confirmations.

How to Minimise Slippage Risks

While slippage cannot be entirely eliminated, there are effective strategies traders can employ to significantly reduce its likelihood and impact. Implementing careful order management and choosing optimal trading conditions are crucial aspects of slippage mitigation.

1. Use Limit Orders

One of the most efficient ways to reduce slippage is by using limit orders instead of market orders. A limit order specifies the maximum price you're willing to pay for a buy order or the minimum price you're willing to accept for a sell order, preventing execution at adverse prices.

However, there is a trade-off — your order might not execute at all if the market does not reach your specified limit price. This non-execution risk must be balanced against the potential cost of slippage through market orders.

2. Trade During Peak Liquidity Hours

Strategically timing your trades can help reduce slippage. Markets tend to have more liquidity during certain hours — for example, the overlap of London and New York trading sessions in forex markets or during regular stock market hours on major exchanges.

• For forex traders, the 13:00 – 17:00 GMT window typically offers the highest liquidity.
• Equities show highest liquidity shortly after the market opens and in the last hour of trading.

Trading during high liquidity periods ensures narrower bid-ask spreads and faster, more accurate order execution, reducing the room for slippage.

3. Avoid Trading Around Major News Events

Macroeconomic announcements, earnings reports, and geopolitical events often cause massive market swings, increasing the risk of slippage.

Examples of high-impact events include:

• Central bank interest rate decisions
• Non-farm payroll reports (NFP)
• Inflation and GDP announcements

Traders can consult economic calendars to steer clear of these periods unless they are specifically engaging in news trading strategies that factor in slippage risk.

4. Choose a Reliable Broker

Your choice of broker can significantly impact the level of slippage you experience. Look for brokers with:

• Tight spreads and competitive execution speeds
• Low latency trading infrastructure
• Direct market access or ECN execution models

Reviewing broker execution policies and user reviews can help determine their effectiveness in minimising slippage.

5. Implement Stop-Loss and Take-Profit Orders Wisely

If your strategy involves stop-loss orders, set them at sensible levels that account for potential slippage during volatile moments. Stop orders will be executed as market orders once triggered, and excessive slippage can occur if placed too close to current price levels during low liquidity periods.

6. Use Advanced Order Types or Trading Algorithms

Many platforms now offer advanced order types like stop-limit and trailing stops or provide access to trading algorithms. These tools help limit execution risk and optimise trade entry and exit points.

Automated trading systems can also place and manage orders more quickly than manual execution, reducing the lag-related slippage especially in high-frequency markets.

7. Monitor Network and System Performance

Retail traders should ensure their trading setup includes a stable internet connection and fast hardware. System delays or lags can cause missed trades or orders filled at unfavourable prices — which in effect is a technical form of slippage.

Using Virtual Private Servers (VPS) near the broker’s data centres is another effective method to reduce latency, especially in algorithmic or high-speed trading environments.

The Impact of Slippage on Strategy

Slippage, although often subtle in individual trades, can have a meaningful long-term effect on a trading strategy’s profitability. It becomes especially critical in strategies that rely on high-frequency execution, tight margins, or rapid entries and exits. Understanding how slippage interacts with your overall trading plan is essential for risk management.

Portfolio Performance and Slippage

Over time, cumulative slippage can erode your annualised returns, particularly if you trade frequently. For instance, if each trade incurs a slippage of 0.1% and you're executing 300 trades annually, this results in a 30% potential cost against capital deployed.

To mitigate, it is important to build slippage assumptions into portfolio performance models. This ensures a more realistic outlook of expected returns and drawdowns, excluding idealised fills.

Backtesting and Optimisation

When backtesting automated or systematic strategies, traders often mistakenly assume perfect trade execution at precise prices. In reality, slippage and transaction costs should be factored into backtesting models to obtain valid performance metrics.

A robust backtest should include variables such as:

• Average historical slippage based on volatility levels
• Broker execution lag or delay
• Tick size movement simulation based on liquidity

Tools like Monte Carlo simulations and walk-forward optimisation tests that incorporate slippage provide more accurate performance forecasts.

Effect on Risk-Reward Ratios

Slippage can distort expected risk-reward ratios. For example, if a strategy targets a 2:1 reward-to-risk ratio per trade, and slippage consistently reduces the reward side, the ratio drops closer to 1.5:1 or lower, changing performance expectations significantly.

To counter this, traders can either widen target profit levels or reduce the risk per trade to maintain a desirable ratio while accounting for potential slippage margins.

Strategies More Prone to Slippage

Some trading strategies are more sensitive to slippage than others:

• Scalping: Since scalpers rely on tiny price movements, even small slippage can wipe out the intended profit margin.
• News-based Trading: High volatility makes order execution uncertain and slippage-prone.
• High-Frequency Trading (HFT): Speed is critical, and microsecond delays can mean severe slippage and losses.

Longer-term trend-trading strategies or position trading tend to be less affected, as the impact of a few pips or points often gets absorbed within larger market movements.

Mitigating Strategy-Level Slippage

To minimise slippage at the strategy level, consider the following:

• Build realistic buffers in risk assessments
• Test with different levels of assumed slippage
• Avoid over-optimising strategies based on historical perfect fills

The best approach is an honest, conservative appraisal of how markets truly function, accepting that real-world frictions like slippage exist and planning accordingly.

In summary, while slippage is an inevitable part of active market engagement, understanding its nuances and pre-emptively building protections into both execution and strategy logic can help traders navigate its impact efficiently.