The difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to sell it for is called the bid-ask spread. Liquid assets, such as Bitcoin, have a smaller spread compared to less liquid and lower trading volume assets.
Slippage occurs when the final transaction price differs from the initial request, often happening when executing market orders. If there is insufficient liquidity in the market to fill your order or if the market is volatile, the final order price may change. To combat slippage on illiquid assets, you can try breaking down the order into several parts.
Introduction
When buying and selling assets on a cryptocurrency exchange, market prices are directly linked to supply and demand. Besides price, there are other crucial factors to consider, such as trading volume, market liquidity, and order types. Depending on market conditions and the types of orders you use, you may not always get the desired price for your trade.
Buyers and sellers aim to get the most favorable price for themselves, creating a spread between the bids of the two sides (the bid-ask spread). Depending on the volume of the asset you want to trade and its volatility, you may also encounter slippage (more on this below). So, to avoid surprises, it's helpful to familiarize yourself with the basics of order books on exchanges.
What is the Bid-Ask Spread?
The difference between the highest bid price and the lowest ask price in the order book is called the bid-ask spread. In traditional markets, this difference is often created by market makers or liquidity provider brokers. In cryptocurrency markets, the difference is created by the gap between buy and sell limit orders.
If you want to make an instant purchase at the market price, you'll take the seller's lowest price (ask price). If you want to make an instant sale, you'll take the buyer's highest price (bid price). More liquid assets (e.g., in the Forex market) have a narrower spread between bid and ask, meaning buyers and sellers can execute their orders without causing significant changes in the asset's price. This happens because of the large volume of orders in the order book. A wider spread between bid and ask will lead to more significant price fluctuations when closing large order volumes.
Market Makers and Bid-Ask Spread
The concept of liquidity is crucial for financial markets. If you try to trade on markets with low liquidity, you may wait for several hours or even days until another trader executes your order.
Creating liquidity is important, but not all markets receive liquidity solely from traders. For example, in traditional markets, brokers and market makers provide liquidity in exchange for arbitrage profits.
A market maker can exploit the difference between the bid and ask prices by simply buying and selling an asset simultaneously. By selling at the higher ask price and buying at the lower bid price repeatedly, the market maker can profit from arbitrage on the price difference. Even a small spread can yield significant profit if traded in high volume throughout the day. Assets with high demand have a smaller spread because market makers compete and narrow the price difference.
For instance, a market maker may simultaneously offer to buy BNB at $350 per coin and sell BNB at $351, creating a spread of $1. Anyone looking to trade instantly on the market would have to accept these conditions. Thus, the spread becomes pure arbitrage profit for the market maker who sells what they buy and buys what they sell.
Market Depth Chart and Spread
Let's look at some real examples of cryptocurrencies and the relationship between volume, liquidity, and the difference between bid and ask prices. On the Binance exchange interface, you can easily see the difference between bid and ask prices by switching to the Depth chart. This button is located in the top right corner of the chart area.
The [Depth] option is the depth chart of an asset's order book. The green bid chart on the market, like the red ask chart, shows the number of orders and their prices. The gap between these charts is the bid-ask spread, which can be calculated by subtracting the green bid price of demand from the red ask price of supply.
As we mentioned earlier, there is a relationship between liquidity and narrow spreads. Trading volume is a widely used liquidity indicator, so we expect to see higher volumes with smaller spreads between bid and ask prices as a percentage of the asset price. Highly liquid cryptocurrencies, stocks, and other assets have much greater competition among traders seeking profit from the bid-ask spread.
Percentage Bid-Ask Spread
To compare the difference between the selling price and the buying price (bid-ask spread) of various cryptocurrencies or assets, we need to evaluate it in percentage terms. The calculation is simple:
(Ask Price - Bid Price) / Ask Price x 100 = Percentage Spread
Let's take BIFI as an example. At the time of writing, BIFI had a selling price of $907 and a buying price of $901. This difference gives us a spread of $6 between the selling price and the buying price. Dividing $6 by $907, then multiplying by 100, we get the final percentage difference between the selling price and the buying price, approximately equal to 0.66%.
Assuming Bitcoin has a $3 difference between its selling and buying prices. This is half the spread compared to BIFI, and if we compare them in percentage terms, Bitcoin's spread between the selling and buying prices is only 0.0083%. BIFI also has significantly lower trading volume, confirming our theory that less liquid assets have wider spreads between the selling and buying prices.
A smaller spread in Bitcoin allows us to draw some conclusions. An asset with a smaller percentage difference between the selling and buying prices is likely more liquid. If you want to execute large market orders for liquid assets, the risk of receiving an unexpected price is generally much lower.
What is Slippage?
Slippage is a common phenomenon in markets with high volatility or low liquidity. Slippage occurs when a trade is executed at a price different from the trader's expectations.
For instance, suppose you want to place a large market order to buy at $100, but there isn't enough liquidity in the market to fill your order at that price. As a result, you'll have to take subsequent orders (above $100) until your order is completely filled. This will lead to the average price of your purchase being higher than $100, which is what we call slippage.
In other words, when you create a market order, the exchange automatically matches your purchase or sale with limit orders in the order book. The order book finds the best price for you, but if the volume at the desired price is insufficient, you'll move up the order chain. This process results in the market filling your order at unexpected prices.
In cryptocurrency, slippage is a common occurrence for market makers and decentralized exchanges. The difference can be more than 10% from the expected price for volatile or illiquid altcoins.
Positive Slippage
Slippage doesn't necessarily mean you'll get a worse price than expected. Positive slippage can occur if the price decreases when you place a buy order or increases when you place a sell order. Although uncommon, positive slippage can occur in some highly volatile markets.
Resisting Slippage
Some exchanges allow you to manually set the acceptable level of slippage to limit the potential deviation from the price. This option can be found in automated market makers such as PancakeSwap on the BNB Smart Chain and Uniswap on Ethereum.
The slippage level you set can affect the execution time of your order. If you set a low slippage level, your order may take a long time to fill or may not fill at all. If you set the level too high, another trader or bot may notice your pending order and create an order at the highest price you're willing to pay.
Minimizing Negative Slippage
While avoiding slippage altogether is not always possible, there are some strategies you can use to try to minimize it.
Instead of placing a large order, try splitting it into smaller blocks. Monitor the order book carefully to place orders that do not exceed the available volume.
If you are using a decentralized exchange, don't forget to consider the commission. Some networks have significant fees depending on blockchain traffic, which can offset any benefits you gain from avoiding slippage.
Dealing with low-liquidity assets, your trading can significantly impact the asset's price. While one transaction may have minor slippage, many others can greatly affect the price.
Use limit orders. These orders ensure that you get the desired price or better when trading. Although you sacrifice the speed of market orders, you can be sure that you won't experience negative slippage.
Conclusion
When trading cryptocurrency, remember that spread or slippage can alter the final price of your transactions. You may not always be able to avoid them, but it's worth considering when making decisions. For small trades, this may be insignificant, but for large volumes, the average price may end up significantly higher than expected.
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