Slippage is a potential problem in all financial markets. A trader is said to suffer from slippage when a financial asset moves against him during the small lag between the time he enters an order and the order is executed. Particularly in forex, where traders make fairly small profits on the average trade, slippage can wipe out an entire day's gain. Traders can, however, take precautions against slippage.
Market vs Limit Orders
Slippage can only occur when a trader places a market order. Such orders entitle the broker to buy or sell an asset at the prevailing market price. If, for example, the British pound is trading at $1.55, and the trader thinks this is an acceptable level to purchase pounds, he may place a market buy order. If he has $155 in his account, he will end up purchasing 100 GBP at the prevailing market prices. In a limit order, the trader will specify the most he wishes to pay for an asset. A limit order may specify a price of no more than $1.54 per GBP, for example. If the trader places such an order and the present price is at $1.55, he will only be able to buy if the price declines to $1.54.
Since the market order implies that the broker has legal authority to buy the foreign currency at the prevailing prices, there is always a chance that the prevailing price will move by the time the order gets executed. The trader may see a price of $1.55 and deem it a reasonable level at which to buy. Immediately after he places a buy order, however, the price may move to $1.56, making it impossible for him to afford 100 GBP with the $155 he has in his account. Or, if he has enough dollars in the account, he may be able to purchase GBP but end up paying more than he would have liked. This price change that results in a different transaction price than what the trader saw on his screen when he placed the order is called slippage.
Downside of Limits
Traders can avoid slippage by simply specifying the highest price they are willing to pay when buying or the lowest price they are willing to accept in a sale; in other words, by using limit orders. The risk, however, is that the order may never get executed. Even if the trader specifies a limit of $1.56 for a purchase when transactions are occurring at $1.55, the price may jump to $1.57 by the time the broker attempts to execute the order. This may result in not being able to buy any GBP at all. Especially when the market is moving up swiftly, being left out as a result of such a limit order would mean losing a profitable trade.
While a trader may end up paying more for a currency as a result of slippage, the opposite can also occur. The price may move down between the time she enters her order and the order is executed, resulting in a more favorable purchase price. In theory, there is a 50-50 chance that the price will move either in favor of or against the trader as a result of slippage. Whether the trader wishes to take this 50-50 chance or would rather avoid unfavorable slippage but instead take the risk of no execution of the trading order depends on her trading strategy.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.