TL;DR

The bid-ask spread is the difference between the lowest price asked for an asset and the highest bid price. Liquid assets like Bitcoin have smaller spreads than assets with lower liquidity and trading volume.

Slippage occurs when a trade is completed at a different average price than originally requested. This often happens when executing market orders. If there is insufficient liquidity to complete an order or the market becomes volatile, the final order price may change. To combat slippage with low liquidity assets, you can try splitting orders into several small parts.

Introduction

When buying and selling assets on crypto exchanges, market prices are directly related to supply and demand. Apart from price, other important factors to consider are trading volume, market liquidity, and order type. Depending on market conditions and the type of order used, you may not always get the price you want for a trade.

There is constant negotiation between buyers and sellers which creates a spread between the two sides (the bid-ask spread). Depending on the number of assets you wish to trade and their volatility, you may also experience slippage (more on this later). So, to avoid the unexpected, having some basic knowledge of an exchange's order book will be beneficial.

What is a bid-ask spread?

The bid-ask spread is the difference between the highest bid price and the lowest ask price of an order book. In traditional markets, spreads are often generated by market makers or broker liquidity providers. In the crypto market, the spread is the result of the difference between the limit orders of buyers and sellers.

If you want to make an instant purchase at market price, you must accept the lowest ask price from a seller. If you want to make an instant sale, you will take the highest bid price from a buyer. More liquid assets (such as forex) have narrower bid-ask spreads, meaning buyers and sellers can execute orders without causing significant changes in the price of the asset. This is due to the large volume of orders in the order book. A wider bid-ask spread will have more substantial price fluctuations when completing large volume orders.

Market makers and bid-ask spreads

The concept of liquidity is important for financial markets. If you try to trade in a market with low liquidity, you may have to wait several hours or even days for another trader to match your order.

Creating liquidity is important, but not all markets have enough liquidity from individual traders alone. For example, in traditional markets, brokers and market makers provide liquidity in exchange for arbitrage profits.

Market makers can benefit from bid-ask spreads simply by buying and selling assets simultaneously. By consistently selling at the higher ask price and buying at the lower bid price, market makers can view the spread as an arbitrage profit. Even small spreads can provide significant profits if traded in large amounts throughout the day. Assets that are in high demand have smaller spreads because market makers are separate and narrow the spread.

For example, a market maker could offer to buy BNB for $350 per coin and then sell BNB for $351 simultaneously, creating a spread of $1. Anyone who wants to trade instantly in the market must fulfill their position. The spread is now pure arbitrage profit for market makers who sell what they buy and buy what they sell.

Depth diagram and bid-ask spread

Let's dive into some real-world cryptocurrency examples and the relationship between volume, liquidity, and bid-ask spread. In the Binance exchange UI, you can easily see the bid-ask spread by switching to the [Depth] chart view. This button is in the upper right corner of the diagram area.

The [Depth] option displays a graphical representation of an asset's order book. You can see the bid quantity and price in green and the ask quantity and price in red. The gap between the two areas is the bid-ask spread which can be calculated by subtracting the green bid price from the red ask price.

As we mentioned earlier, there is an implied relationship between liquidity and smaller bid-ask spreads. Trading volume is a frequently used indicator of liquidity, so higher volume with a lower bid-ask spread can be seen as a percentage of an asset's price. Cryptocurrencies, stocks, and other widely traded assets have higher competition among traders looking to take advantage of bid-ask spreads.

Bid-ask spread percentage

To compare the bid-ask spread of different cryptocurrencies or assets, we must evaluate them in percentage terms. The calculation is simple:

(Ask Price - Bid Price)/Ask Price x 100 = Bid-Ask Spread Percentage

Let's use BIFI as an example. At the time of writing this article, BIFI has an ask price of $907 and a bid price of $901. This difference results in a bid-ask spread of $6. $6 divided by $907, then multiplied by 100 will yield a final bid-ask spread percentage of approximately 0.66%.

Now, assume that Bitcoin has a bid-ask spread of $3. Even though the value is half that of the BIFI example, when comparing the two in percentage terms, Bitcoin's bid-ask spread is only 0.0083%. BIFI also has much lower trading volume which supports our theory that less liquid assets tend to have larger bid-ask spreads.

Bitcoin's narrower spread allows us to draw some conclusions. Assets with a smaller bid-ask spread percentage are likely to be much more liquid. If you want to execute a large market order, usually the risk of you having to pay an unexpected price is smaller.

What is slippage?

Slippage is a common occurrence in markets with high volatility or low liquidity. Slippage occurs when a trade is completed at a different price than expected or requested.

For example, assume that you want to place a large buy market order at $100, but the market does not have the liquidity necessary to fill the order at that price. As a result, you will have to take subsequent orders (above $100) until the order is completely filled. This will cause your average purchase price to be higher than $100 and that is what is called slippage.

In other words, when placing a market order, an exchange will automatically match the purchase or sale to the limit order in the order book. The order book will match you with the best price, but you will start to move higher up the order chain if the volume is not enough for the desired price. This process causes the market to fill your order at a different and unexpected price.

In crypto, slippage is a common occurrence in automated market makers and decentralized exchanges. Slippage can be above 10% of the expected price for altcoins that are volatile or have low liquidity.

Slippage positif

Slippage doesn't necessarily mean that you'll get a worse price than expected. Positive slippage can occur if the price falls when placing a buy order or the price increases when placing a sell order. Although not common, positive slippage can occur in some highly volatile markets.

Slippage tolerance

Some exchanges allow you to manually set a slippage tolerance level to limit the slippage you may experience. You will see this option in automated market makers, such as PancakeSwap on Binance Smart Chain and Uniswap on Ethereum.

The amount of slippage set can have a cumulative effect on the time it takes to complete your order. If you set low slippage, orders can take a long time to fill or not fill at all. If you set it too high, other traders or bots can see your pending orders and get ahead of you.

In this case, front running occurs when another trader sets a higher gas fee than you to buy the asset first. Then, the front runner enters another trade to sell it to you at the highest price you are willing to accept based on slippage tolerance.

Minimizes negative slippage

While you can't always avoid slippage, there are several strategies you can use to try to minimize it.

1. As an alternative to placing a large order, try breaking it up into several smaller blocks. Keep an eye on the order book to spread out your orders so as not to place orders that are larger than the available volume.

2. If you use a decentralized exchange, don't forget to factor in transaction fees. Some networks have high fees depending on blockchain traffic which can negate any profits gained, thereby avoiding slippage.

3. If you deal in assets with low liquidity, such as small liquidity pools, your trading activity can significantly impact the price of the asset. A single transaction may experience a small amount of slippage, but a large number of small transactions will affect the price of the next block of transactions you create.

4. Use limit orders. This order ensures you get the desired price or better when trading. Despite sacrificing market order speed, you can be confident that you will not experience negative slippage.

Closing

When trading cryptocurrencies, don't forget that the bid-ask spread or slippage can change the final price of the trade. You can't always avoid it, but it's something to consider when making your decision. For smaller trades this can be minor. However, remember that with large volume orders, the average price per unit may be higher than expected.

For anyone experimenting with decentralized finance, understanding slippage is an important part of the basics of trading. Without some basic knowledge, you are at serious risk of losing money due to excessive front-running or slippage.