Content
Bid-ask spread is the difference between the lowest ask price and the highest bid price. Liquid assets such as Bitcoin have a narrower spread than assets with less liquidity and less trading volume.
Slippage occurs when a trade settles at an average price different from the original asking price. This often happens when executing market orders. If there is insufficient liquidity to fill your order or the market is volatile, the final price of the order may change. To prevent assets with low liquidity from slipping, you can try splitting your order into smaller parts.
Introduction
When you buy and sell assets on a cryptocurrency exchange, market prices are directly related to supply and demand. In addition to price, other important factors to consider are 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 per trade.
Constant negotiations are conducted between buyers and sellers, which create a spread between the two parties (bid-ask spread). Depending on the amount of the asset you want to trade and its volatility, you may also experience slippage (more on that later). Thus, to avoid surprises, getting a basic knowledge of the exchange's order book will be of great importance.
What is a bid-ask spread?
The bid-ask spread is the difference between the highest bid price and the lowest ask price of the order book. In traditional markets, the spread is often created by market makers or brokerage liquidity providers. In cryptocurrency markets, the spread is the result of the difference between the limit orders of buyers and sellers.
If you want to buy at market price instantly, you need to accept the lowest asking price from the seller. If you want to make an instant sale, you will get the highest possible price from the buyer. The most liquid assets (such as forex) have a narrower bid-ask spread, which means that buyers and sellers can execute their orders without causing significant changes in the asset's price. This is due to the large volume of orders in the order book. A wider bid-ask spread will have more significant price fluctuations when closing large volume orders.
Market makers and bid-ask spread
The concept of liquidity is very important to financial markets. If you try to trade in markets with low liquidity, you can wait hours or even days for another trader to match your order.
Creating liquidity is important, but not all markets get the necessary liquidity from traders alone. For example, in traditional markets, brokers and market makers provide liquidity in exchange for arbitrage profits.
A market maker can take advantage of a bid-ask spread by simply buying and selling an asset at the same time. By selling at the higher ask price and buying at the lower bid price over and over again, market makers can use the spread as an arbitrage profit. Even a small spread can yield significant profits if you trade a large amount throughout the day. Assets in high demand have tighter spreads as market makers compete and narrow it.
For example, a market maker can simultaneously bid to buy BNB at $350 per coin and sell BNB at $351, creating a $1 spread. Anyone who wants to trade instantly in the market will have to take their positions. The spread now represents a net arbitrage profit for the market maker, who sells what he buys and buys what he sells.
Chart depth and bid-ask spread
Let's look at some real-world examples of cryptocurrencies and the relationship between volume, liquidity and bid-ask spread. In the interface of the Binance exchange, you can easily see the bid-ask spread by switching to the [Depth] view mode of the chart. This button is located in the upper right corner of the graph area.
The [Depth] parameter shows a graphical representation of the asset's order book. You can see the amount and price of bids in green, and the amount and price of asks in red. The gap between these two areas is the bid-ask spread, which you can calculate by taking the red ask price and subtracting the green bid price.
As we mentioned earlier, there is a relationship between liquidity and lower bid-ask spreads. Trading volume is a common indicator of liquidity, so with high volumes we would expect to see a smaller percentage of the bid-ask spread relative to the asset price. Given the popularity of some cryptocurrencies, stocks and other assets, high competition is created between traders willing to take advantage of the bid-ask spread.
Bid-ask spread percentage
To compare the bid-ask spread of different cryptocurrencies or assets, we need to evaluate it as a percentage. The calculation is simple:
(Ask price - Bid price)/Ask price x 100 = Percentage bid-ask spread
Let's take BIFI as an example. At the time of writing, the ask price of BIFI was $907, and the bid price was $901. This difference gives us a bid-ask spread of $6. $6 divided by $907 and then multiplied by 100 gives a final bid-ask spread percentage of approximately 0.66%.
Now let's assume that the Bitcoin bid-ask spread is $3. While this is half of what we've seen with BIFI, when we compare them percentage-wise, Bitcoin's bid-ask spread is just 0.0083%. BIFI also has significantly lower trading volume, supporting our theory that less liquid assets tend to have larger bid-ask spreads.
Bitcoin's narrower spread allows us to draw some conclusions. An asset with a lower bid-ask spread percentage is likely to be much more liquid. If you want to execute large market orders, there is generally less risk that you will have to pay a price that you did not expect.
What is slippage?
Slippage is common in markets with high volatility or low liquidity. Slippage occurs when a trade is executed at a price different from the trader's expected or requested price.
For example, let's say you want to place a large market order to buy $100, but the market doesn't have the necessary liquidity to fill your order at that price. As a result, you will have to accept further orders (more than $100) until your order is filled in full. This will cause your average purchase price to be above $100, which is what we call slippage.
In other words, when you create a market order, the exchange automatically matches your buy or sell to limit orders in the order book. The order book will match you to a better price, but you will start moving further up the order chain if the volume is not enough for the desired price. This process results in the market executing your orders at unexpected, different prices.
In cryptocurrency, slippage is common in automated market makers and decentralized exchanges. Slippage can be more than 10% of expected price for volatile or illiquid altcoins.
Positive slippage
Slippage doesn't necessarily mean you'll get a lower price than expected. Positive slippage can occur if the price is decreasing when you place a buy order, or increasing if you are placing a sell order. Although this is rare, positive slippage can occur in some highly volatile markets.
Slip resistance
Some exchanges allow you to manually set a slip resistance level to limit any slippage that may occur. You will see this option in automated market makers such as PancakeSwap on Binance Smart Chain and Uniswap on Ethereum.
The amount of slippage you set can affect the time it takes to execute your order. If you set a low slippage, your order may take a long time to execute or may not execute at all. If you set the value too high, another trader or bot may see your pending order and overtake you.
In this case, the trigger occurs when another trader sets a higher gas fee and buys the asset first. The lead bidder then enters another trade to sell it to you at the highest price you are willing to accept based on your resistance to slippage.
Minimization of negative slippage
While you can't always avoid slipping, there are a few strategies you can use to try to minimize it.
1. Instead of placing a large order, try breaking it into smaller blocks. Keep a close eye on the order book to distribute your orders, trying not to place orders that exceed the available volume.
2. If you use a decentralized exchange, don't forget to factor in transaction fees. Some networks charge huge fees based on blockchain traffic, which can negate any profit you make by avoiding slippage.
3. If you are dealing with assets with low liquidity, such as a small liquidity pool, your trading activity can significantly affect the price of the asset. One transaction may have a small slippage, but many smaller slippages will affect the price of the next block of transactions you make.
4. Use of limit orders. These orders guarantee that you will receive the desired or better price when trading. Although you sacrifice the speed of the market order, you can be sure that you will not experience negative slippage.
Final thoughts
When you trade cryptocurrency, remember that the bid-ask spread or slippage can change the final price of your trades. These phenomena cannot always be avoided, but they should be taken into account when making decisions. When executing small orders, such phenomena may not be felt so acutely, but the average price of large orders per unit may turn out to be much higher than expected.
For those experimenting with decentralized finance, understanding slippage is an important part of trading fundamentals. Without the basics, you risk losing your money by getting ahead or slipping too much.
