TL;DR - SUMMARY

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

Slippage occurs when a trade settles at an average price that is different from what was initially requested. It often happens when executing market orders. If there is not enough liquidity to fill your order or the market is volatile, the final order price may change. To combat slippage with low-liquidity assets, you can try splitting your order into smaller parts.

Introduction

When you buy and sell assets on a crypto 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 order types you use, you will not always get the price you want for a trade.

There is a constant negotiation between buyers and sellers that creates a spread between the two parties (bid-ask spread). Depending on the amount of an asset you want to trade and its volatility, you may also encounter slippage (more on this later). So, to avoid any surprises, getting a basic understanding of an exchange's order book will be of great help.

What is the 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, the spread is usually created by market makers or liquidity providers to brokers. In cryptocurrency markets, the spread is the result of the difference between buyer and seller limit orders.

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

Market makers and the bid-ask spread

The concept of liquidity is fundamental for financial markets. If you try to make a trade in low liquidity markets, you may find yourself waiting 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. In traditional markets, for example, brokers and market makers provide liquidity in exchange for arbitrage profits.

A market maker can take advantage of a bid-ask spread simply by buying and selling an asset simultaneously. By selling at the highest bid price and buying at the lowest bid price over and over again, market makers can take the spread as arbitrage profit. Even a small spread can provide significant profits if you trade large amounts throughout the day. Assets with high demand have smaller spreads as market makers compete and reduce the spread.

For example, a market maker can simultaneously offer to buy BNB for 350 USD per coin and sell BNB for 351 USD, creating a spread of 1 USD. Anyone who wants to make a trade instantly in the market will have to honor their positions. The differential is now pure arbitrage profit for the market maker who sells what he buys and buys what he sells.

Bid-ask spread and depth charts

Let's take a look at 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 chart area.

The [Depth] option displays a graphical representation of an asset's order book. You can see the quantity and price of bids in green, along with the quantity 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 above, there is an implicit relationship between liquidity and smaller bid-ask spreads. Trading volume is a commonly used liquidity indicator, so we expect to see higher volumes with smaller bid-ask spreads as a percentage of an asset's price. Cryptocurrencies, stocks, and other heavily traded assets have much more competition among traders looking to take advantage of the bid-ask spread.

Bid-ask spread percentage

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

(ask price - bid price) / ask price x 100 = Bid-ask spread percentage

Let's take BIFI as an example. At the time of writing, BIFI had an ask price of 907 usd and a bid price of 901 usd. This difference gives us a bid-ask differential of 6 usd. 6 usd divided by 907 usd, then multiplied by 100, gives us a final bid-ask spread percentage of approximately 0.66%.

Now suppose Bitcoin has a bid-ask spread of 3 usd. While it is half of what we saw with BIFI, when we compare them in percentage terms, Bitcoin's bid-ask spread is only 0.0083%. BIFI also has significantly lower trading volume, supporting our theory that less liquid assets tend to have higher bid-ask spreads.

Bitcoin's tighter 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 of having to pay a price you were not expecting.

What is slippage?

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

For example, suppose you want to place a large buy market order at $100, but the market does not have the necessary liquidity to execute your order at that price. As a result, you will have to take subsequent orders (above 100 usd) until your order is completely filled. This will make the average price of your purchase greater than 100 usd, and that is what we call slippage.

In other words, when you create a market order, an exchange automatically matches your buy or sell with limit orders from the order book. The order book will match you with the best price, but will start moving up the order chain if there is insufficient volume for the desired price. This process results in the market filling your order at different and unexpected prices.

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

Positive slip‍

Slippage doesn't necessarily mean you'll end up with a worse price than expected. Positive slippage can occur if the price decreases while you place your buy order or increases if you place a sell order. Although rare, positive slippage can occur in some highly volatile markets.

Slip tolerance‍

Some exchanges allow you to set a slippage tolerance level manually to limit any slippage you may experience. You'll see this option on automated market makers like PancakeSwap on Binance Smart Chain and Uniswap on Ethereum.

The amount of slippage you set can have a ripple effect on the time it takes for your order to settle. If you set the slippage low, your order may take a long time to complete or not complete at all. If you set it too high, another trader or bot can see your pending order and take advantage of you.

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

Minimize negative slippage

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

1. Instead of placing a large order, try breaking it into smaller blocks. You have to keep an eye on the order book to distribute your orders, making sure not to place orders that exceed the available volume.

2. If you are using a decentralized exchange, don't forget to take transaction fees into account. Some networks have high fees based on blockchain traffic that can negate any profits you make, preventing slippage.

3. If you are dealing with low liquidity assets, such as a small liquidity pool, your trading activity could significantly affect the price of the asset. A single transaction may experience a small amount of slippage, but many smaller transactions will affect the price of the next block of transactions you make.

4. Use limit orders. These orders ensure that you get the price you want or a better one when trading. While you sacrifice the speed of a market order, you can be sure that you will not experience any negative slippage.

In conclusion

When trading cryptocurrencies, don't forget that a bid-ask spread or slippage can change the final price of your trades. You can't always avoid them, but it's worth taking this into account in your decisions. For smaller trades, this may be minimal, but 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 trading basics. Without some basic knowledge, you run a high risk of losing your money because someone took advantage of you or excessive slippage.