Negative slippage can cut into your trading profits and separate newbies from experienced traders. With the right strategy, you can minimize slippage and its adverse effects. But first, you must understand the fundamentals of the bid-ask spread, slippage, and related concepts.
Let’s dive in.
Bid-ask spread is the difference between the “ask” price (the lowest price at which sellers are willing to sell) and the “bid” price (the highest price at which buyers are ready to buy). Slippage is the difference between the price at which you expect to buy or sell a crypto asset and the actual price at which the trade is finally executed.
To a trader, slippage is a vital consideration because it can affect your bottom line. The danger of slippage is the risk of loss, especially when the order is of significant size. The risk of slippage is more pronounced in turbulent markets.
In this guide, you’ll learn about the bid-ask spread and slippage, and how to handle their impact.
Liquidity measures how easily a cryptocurrency can be bought or sold in the market without significantly affecting its market value. A coin or token with strong liquidity will have many sellers and buyers, and a relatively deep order book waiting for orders.
This abundance of buyers and sellers narrows the bid-ask spread. As a result, the bid-ask spread is a good measure of liquidity. The smaller the bid-ask spread, the stronger the liquidity of the cryptocurrency asset. Likewise, with lower liquidity comes more potential for volatility and slippage.
Measuring Liquidity: Some Common Terms
Order Book: A ledger that displays all buy and sell instructions (orders) from the market. The order book shows the current market or order depth.
To execute a trade, bids, and asks are paired up as soon as their requirements are fulfilled. There are two main types of orders:
- Market order: Refers to the immediate execution of an order at the best available price. These orders are filled first by buyers and sellers with orders currently in the books.
- Limit order: A limit order is an instruction from a trader to buy or sell a fixed number of assets at a specified price or better. A sell limit order can only be executed at that price, or at a higher one. Similarly, a buy limit order would only execute at the limit price or lower. If the asset doesn’t trade at the limit price or better, no trade will be executed.
Order depth: The total number of limit orders on the order book ledger. Order depth can be calculated by adding up the volume of limit orders placed.
For example, the order depth in the image below shows in real-time the number of buyers and sellers with orders awaiting execution in the order book.
Under the “Price” column, the prices in red are the selling prices, and the prices in green are the buying prices.
The “Quantity” column shows the number of units at the stipulated price, while the “Total” column represents the corresponding accumulated number of contracts.
In this illustration, the current best ask price is “Sell” $31,985.50, and the best bid price is “Bid” $31,985.00. In order for Bitcoin to go up to $31,986.00, buyers must take up all of the 2,806,583 contracts at $31,985.50.
The greater the depth of an order book, the better its liquidity. A deep market offers the ability to maintain prices when executing large transactions. Greater order depth also means a lower chance of price manipulation.
Slippage: The difference between the expected price of a trade and the actual price at which it executes. There might not be enough interest or volume to fulfill an order at the expected price, especially when executing large orders. When this happens, a part of the order can be filled at the next available price. Slippage also occurs in times of high market volatility.
At such times, the bid-ask spread may change between the time a trader places a market order and the time the market maker or exchange executes the order. Slippage is then negatively correlated with liquidity. Liquidity and slippage have an inverse relationship: when liquidity is high, slippage is low, and with low liquidity, slippage is high.
Importance of Liquidity
Poor liquidity leads to price instability for an asset, which means that slippage and price manipulations are likely to increase. Lower liquidity also means longer waiting times, which could adversely affect traders, especially during a market swing. A good trader understands how liquidity impacts their transactions and develops strategies for picking assets with suitable liquidity.
What Is Bid-Ask Spread?
Bid-ask spread is an important trading concept to understand. Here’s how it works.
Bid vs. Ask
The bid price is the price that a trader is willing to pay for an asset. When you place a buy order, you bid for the asset. Meanwhile, the asking price is the sale price of a crypto asset that will seal the deal.
The bid-ask spread is the difference between the lowest price a seller is willing to accept (the ask price) and the highest price a buyer is willing to pay (the bid price). In markets, the spread results from the difference between buyers’ and sellers’ limit orders. These orders show up as bids and ask in an order book.
The Bid-Ask Spread Percentage Calculation
Comparing the bid-ask spread of different crypto assets is best done using percentages. The formula for the bid-ask percentage calculation is simple:
Bid-Ask Spread Percentage = [(Ask Price − Bid Price) ÷ Ask Price] × 100
For instance, a coin trading at $3.95/$4.05 means the bid price is $3.95, and the asking price is $4.05. You can calculate the bid-ask spread percentage using the given formula:
[(4.05 − 3.95) ÷ 4.05] × 100 = 2.5% (rounded up to the nearest tenth)
The smaller the bid-ask spread percentage of a crypto asset, the more liquid it tends to be. If you’re executing substantial market orders, you’ll have a lower risk of paying an unexpected price. This means your slippage is minimal.
How Slippage Happens
Slippage happens when you create a market order, and an exchange matches your buy or sell request with the limit orders in the order book. The order book will try to fill your order at the best price. However, if there is insufficient volume at your desired price, the order book will go up the order chain for the next best price. In the end, your order may execute at a less desirable price than expected.
If you want to quickly buy 1,000 units of an asset currently trading at $100 but the market doesn’t have enough liquidity to execute your order, your execution price will be different. You’ll have to take the orders above your bid price of $100 until your order is completed. This will make your average purchase price higher than the intended $100.
Slippage can be common in decentralized exchanges, especially without dedicated market makers. It’s more likely to occur in high volatility, low liquidity markets.
Slippage isn’t always bad for business. Positive slippage occurs when you place a buy order and the asset price decreases. That is, the final execution price is lower than expected for your buy market order. Similar positive slippage occurs when you make a sell order and the price increases. If the final execution price is better than the expected one, your positive slippage actually results in a more favorable trade for you.
Negative slippage is a major concern for any trader. If the price of an asset increases after placing a buy order, or reduces after you enter a sell order, you may face negative slippage.
How to Minimize Slippage
Slippage is inevitable during fast-paced trading when you’re trying to execute orders quickly. However, you can minimize negative slippage by:
- Splitting your orders. Rather than trying to execute a single large order immediately, split it into smaller units. Closely monitor the order book to spread out your orders, and avoid placing orders larger than the available volume allows.
- Using Limit orders. These ensure you get your expected buy or ask price — or even better. Limit orders may not be fast, and you could miss cashing out on some transactions if you set your tolerance level too low. But they ensure you won’t suffer any negative slippage.
The Bottom Line
Trading in cryptocurrencies can be highly profitable, but it carries risks. Aside from the inherent market volatility, there is also the potential for trading losses from the bid-ask spread and slippage. While you can’t always avoid these trading costs, it pays to factor them in while making trade decisions. This is especially true for larger volume trades, where the average price per cryptocurrency might end up higher or lower than expected.
Financial markets are structured to provide traders with as many trading options as possible, but market participants still determine whether slippage occurs, as well as its ultimate impact. Informed traders pay keen attention to liquidity constraints to maximize trading profits.