Slippage in forex trading
Is slippage a bad thing in forex trading? This is a question that the majority of beginner traders mull over frequently.
There is no clear cut “yes” or “no” answer to this question.
This is because slippage can be either beneficial or harmful depending on the set of conditions under which it occurs.
To answer this question, this article will provide you with a simple breakdown of the meaning of slippage.
It will also show you different examples to ensure that you understand the concept in depth and apply it in your trading.
First, let us look at the general definitions of some of the terminologies that are relevant to this lesson:
In the stock market, a profitable trade is any transaction from which the executor has the ability to earn a profit.
Conducting a profitable trade does not automatically mean that you will earn a profit; rather, it means that there is a possibility of earning a return.
In such a trade, the expectation is that you will gain a return after your broker has deducted service fees.
Some brokers will also inform you whether the market has positive pointers and warn you when they believe there is extremely minimal or no possibility of earning from such a trade.
Margin is the cash that you invest into a trade. Margin is factored in when determining whether a trade is worthwhile or not.
Theoretically, it is possible to earn a profit from any amount invested if the odds are in your favor.
However, some figures are too meager and therefore can only be truncated.
For example, if you were to make an investment of $20 and earn a profit of 0.00005% from it, it means you have earned a profit of $0.00001.
But the dollar can only quote up to four decimal points, and therefore when this is put into the books of accounts, it means you will not have earned anything in practice.
However, take an investment of $2000 and earn a 0.00005% profit from it.
This is what you get: $0.001, which is a three decimal number and therefore fits into the books.
The more margin an investor has, the higher his or her chances of acquiring a bigger profit. This is precisely the reason why brokers set minimum margins.
When you meet the minimum margin, the broker may also offer you leverage to increase your buying power and therefore raise your profits further.
A leverage is like a “quick loan” except that brokers do not charge direct interests from it.
Most firms allow you to borrow up to 100 percent equivalence of your margin.
For example, when you set a margin of $1000, you can get another $1000 from the brokerage firm and therefore invest a total of $2000.
If all goes well, you will earn higher profits from the latter than you would have earned with your initial amount.
The broker will only take back their $1000 and leave to you all the profits.
But taking a higher leverage also means facing more risks. In case the trade gives a negative return, the broker will demand that you refund the leverage.
Even then, it is not possible to lose everything in a trade because there are systems in place that automatically stop your trade when losses get past a particular limit set by you or the broker.
In FX trade, a spread is the difference between the buying price (ask) of a currency and its selling price (bid).
A spread may be either positive or negative. If you bought £1 using $1.4312 and sold it later for $1.4412, the spread here is $0.0100 or 100 pips.
On the other hand, if you bought £1 at $1.4412 and sold it later at $1.4312, you get a negative spread. In this case, your spread will be negative $0.0100 or -100 pips.
An order is an instruction from an investor to the broker to buy or sell an instrument.
In currency trade, an order may be issued directly or through implied consent in a contract, or conditional settings in an online forex account.
It is in the latter that we get other terms like limit order and market order.
So, what is a slippage?
Slippage is the difference between the preferred buying or selling price when a person places an order, and the actual buying price at which he or she acquires or sells the currency.
Many factors may cause this gap, which leads a person to acquire or sell a currency at a price they did not exactly intend to.
One of these is the person’s choice or when there are no traders wanting to sell or buy at the order price.
Slippage in ask orders
If for instance at the current rate, EUR/USD is 1.0893 and yet the person placed an order to buy €1 at $1.0000, the conditions that the person has outlined in the order will determine whether the broker goes ahead to buy the EUR at the existing rate or cancels the transaction.
If the conditions set allow the broker to proceed with the buying, it means that the investor will acquire less EURs than earlier expected due to its higher cost per unit.
This is known as negative slippage. However, just because the slippage is negative does not mean that the buyer has gone at a loss, neither does it mean that the profit expectation of a buyer is dead.
Profit and loss can only be determined after the person has sold the currency.
If the value of EUR continues to rise, say, to $1.5000, the buyer might sell it at this point and get a spread of $0.4107 ($1.5000-$1. 1.0893).
Therefore, despite the negative slippage in the buy order, the person will have gained profit.
On the other hand, if the value of the EUR falls during the time of selling such that the spread is negative, then a loss results.
Slippage in sell orders (Part 1/3)
An investor who has EUR may wish to sell it and acquire USD. If the seller’s preferred rate is EUR/USD 1.5000, they might get only buyers who are willing to part with a maximum of $1.4000 per EUR. In that case, the person may choose to proceed with the transaction or cancel it depending on the “negotiation” conditions they set out in the sell order. If the conditions allow buying for a EUR/USD 1.4000 transaction, it means that the person will incur a negative slippage.
Slippage in sell orders (Part 2/3)
Just like in the previous case however, a negative slippage on its own does not determine profit or loss, although in this case it determines a fall in profit expectations of the seller.
The seller might have acquired the said EUR at a cheaper price than the $1.4000 that buyers are offering, and so despite the negative slippage, the spread is still positive.
In conclusion, one can casually say that slippage only affects the profit levels of an investor and does not contribute to a profit or loss event in itself.
A positive slippage indicates chances (but does not assure you) of more profits while a negative slippage means lower profits.
Slippage in sell orders (Part 3/3)
One can also say that only a negative spread leads to a loss after a full buy and sell cycle.
But even this is not entirely true as factors such as margin, leverage, taxes, service fees and inflation among others contribute little but significant influences.
To protect their interests, investors use tools such as limit orders and market orders to halt a transaction if they think it will not favor them.
Brokerage accounts may also automatically block certain processes if they believe they might cause dire harm to the investor and, to some extent, to the firms themselves.