Foreign exchange (forex) trading involves buying and selling currencies, with the goal of profiting from favorable exchange rates. However, between the time a trade order is placed and when it is executed, the exchange rate may change unexpectedly. This difference between the expected price of a trade and the price at which it is executed is called slippage. While some slippage is inevitable, traders can take steps to reduce its impact on trading outcomes.

What Causes Slippage in Forex Trading

Volatility and low liquidity are the main reasons slippage occurs in the forex market. Currencies are constantly fluctuating in value, and large trades can impact supply and demand for a currency pair. During periods of high volatility, like news events or sudden market moves, prices can change rapidly. If there is insufficient market liquidity and trading volume, orders may not be filled at the expected rate.

Slippage is most common when trading exotic currency pairs that have lower trading volume. Major pairs like EUR/USD see high liquidity and typically experience less slippage. But emerging market currencies paired with major currencies, like USD/MXN or EUR/TRY, tend to have wider bid-ask spreads due to lower liquidity.

Types of Slippage

There are two main types of slippage in forex trading:

Favorable Slippage

This is when an order executes at a better rate than expected. For example, a trader places a market order to buy EUR/USD at 1.1250, but the order fills at 1.1245. The trader gets a better price than anticipated. However, favorable slippage is less common than unfavorable slippage.

Unfavorable Slippage

Also called negative slippage, this is when a trade is executed at a worse rate compared to the order price. For instance, a trader places a pending order to sell GBP/USD at 1.3000, but the order fills at 1.3005 when triggered. This results in immediate loss due to slippage on the trade. Unfavorable slippage is the more prevalent type seen in forex markets.

Slippage Impact on Trading

Slippage directly impacts the potential profit or loss on each trade. Even seemingly small differences in entry or exit prices per trade can compound over time and substantially affect overall trading performance. For short-term traders making multiple trades daily, slippage costs can really add up.

Let’s see an example of how negative slippage impacts a trader’s bottom line. A trader enters a long EUR/USD position, buying it at 1.1250 instead of their intended entry price of 1.1245. The market moves as the trader expects, and they close the trade at 1.1300 for a gross profit of 50 pips. But due to the 5 pips of negative slippage on entry, the trader’s net profit is only 45 pips.

Over a year of active trading, that kind of slippage differential can result in thousands of dollars in lost profits. For active short-term traders, it pays to be diligent about minimizing slippage.

Ways Traders Can Reduce Slippage

While slippage cannot be avoided completely, traders can employ strategies to decrease its frequency and impact on profits. Some best practices include:

1. Use Limit Orders Instead of Market Orders

With market orders, you accept the current market price at the time the order is filled. But limit orders allow you to specify the entry or exit rate you want. The trade will only be executed if the market reaches your limit price. Though your order may not always be filled, you avoid unfavorable slippage with limit orders.

2. Trade During Peak Volume Hours

Trading session overlaps like when the London and New York markets are open simultaneously tend to have the greatest liquidity and trading volume. Placing trades during peak hours helps ensure pricing accuracy and depth when orders are executed.

3. Be Cautious Around News Events

Major news announcements like employment data, interest rate decisions, and other economic releases can cause volatility and gaps in pricing. Whenever possible, avoid entering trades right before big news events. Use limit orders rather than market orders to control your entry price.

4. Adjust Stop Losses and Limits Accordingly

Keep stop losses wider to account for short-term volatility and slippage on order fills. And set limit orders a few pips below or above your targets. For instance, if you want to take profits at 1.1350, place a limit exit order at 1.1348. This helps ensure you get filled at your desired price.

5. Choose a Well-Regulated Broker with No Dealing Desk

Compare forex brokers and select one with robust trading infrastructure that facilitates tight bid-ask spreads and reliable order execution. Dealing desk brokers have inherent conflict of interest, so it’s best to choose an agency model broker for reduced intervention in your trades. Regulated brokers are obligated to execute orders with best price and speed for clients.

6. Use a Virtual Private Server (VPS)

Latency or network delays between your computer and broker’s servers can result in slippage during order execution. A VPS hosted in close proximity to your broker’s data center minimizes latency for faster trade execution.

7. Use Stop-Limit Orders

Stop-limit orders allow you to set a stop price where the order triggers. Then a secondary connected limit order activates to control your entry or exit price. This combines the market order’s guaranteed fill with a limit order’s price control.

8. Employ an Effective Risk Management System

Leverage your trading capital responsibly, use stop losses on every trade, and size positions appropriately to avoid overexposure. Risk management is key for navigating volatile markets where slippage is common. Avoid placing too many trades at once or oversizing positions.

Proper analysis, vigilant planning, and sound risk practices can reduce slippage costs. But some slippage on forex trades will always persist due to inherent market variables. Traders must account for this friction and its impact on profit targets. With the right expectations, techniques, and tools, forex traders can achieve success over the long-term, even while minimizing slippage on each trade.

Summary: Key Takeaways on Managing Slippage

  • Slippage occurs when orders are executed at different prices than intended, due to volatility and low liquidity.
  • Use limit orders instead of market orders to control entry and exit prices.
  • Trade during peak volume hours for greater precision on order fills.
  • Keep stop losses wide and limit exits a few pips early to account for slippage.
  • Choose a trusted, well-regulated broker and use a nearby VPS server to minimize latency.
  • Employ good risk management techniques, and size trades appropriately to avoid large slippage costs.
  • Anticipate some slippage when trading forex, and factor it into your overall trading plan and profit targets.