Carefully! Lots of text.
The bid-ask spread is the difference between the lowest price asked for an asset and the highest bid price. Liquid assets, such as Bitcoin, have a smaller spread than less liquid assets with lower trading volume.
Slippage occurs when the resulting trade price differs from the original request, which often occurs when market orders are executed. If the market is unstable or insufficiently liquid for your order to be executed, the final order price may change. To prevent slippage of assets with low liquidity, you can try dividing the order into smaller ones.
Introduction
When selling and buying assets on a cryptocurrency exchange, do not forget that market prices are directly related to supply and demand. In addition, it is important to consider trading volume, market liquidity, order types, and overall market conditions that may prevent you from completing a trade at your desired price.
Buyers and sellers strive to get the best price for themselves, which creates a spread between the two sides' offers (bid-ask spread). Depending on the amount and volatility of the asset you are going to trade, there is also a chance of experiencing slippage (more on this below). Thus, having a basic knowledge of the exchange's order book will save you from many unpleasant surprises.
What is the bid-ask spread?
The bid-ask spread is the difference between the highest value of the bid price, or ask price, and the lowest value of the ask price of the order book. In traditional markets, the spread is often created by market makers or brokerage liquidity providers, while in cryptocurrency markets it is the result of the difference between limit orders from buyers and sellers.
If you want to buy instantly at the market price, you will have to accept the highest ask price favorable to the seller. In the case of an instant sale, it will be necessary to accept the buyer's lowest bid price. More liquid assets (such as forex) have tighter spreads, meaning buyers and sellers can fill their orders without significant changes in the price of the asset. This is mainly due to the large volume of orders in the order book. A wider spread will cause significant price fluctuations when large volume orders are closed.
Market Makers and the Bid-Ask Spread
The concept of liquidity is very important in financial markets. In markets with low liquidity, you can wait hours or even days for another trader to execute your order.
Creating liquidity is important, but not all markets receive the liquidity they need from traders alone - in traditional markets, brokers and market makers provide liquidity in exchange for arbitrage profits.
The market maker can use the spread to his advantage by simultaneously buying and selling the asset. By selling high and buying low over and over again, they use the spread to make arbitrage profits. Even a small spread can generate significant profits if traded in large quantities throughout the day. Because of this competition among market makers, assets with high demand tend to have smaller spreads.
For example, a market maker could simultaneously buy BNB for $350 per coin and sell BNB for $351, creating a $1 spread. Anyone who wants to trade the market instantly will have to accept these terms and conditions. The spread now represents a pure arbitrage profit for the market maker, who sells what he buys and buys what he sells.
Market depth chart and spread
Let's look at real-life examples of cryptocurrencies and the relationship between volume, liquidity and spread. If you go to the Binance exchange and turn on the [Depth Charts] view, you can see the bid-ask spread. This button is in the upper right corner of the chart.
[Depth charts] are charts of an asset's order book. The green graph of market supply, as well as the red graph of demand, show the number of applications and their price. The gap between these graphs is the bid-ask spread, which can be calculated by subtracting the green bid price from the red ask price.
As we've said before, there is a relationship between liquidity and tight spreads. Trading volume is a common indicator of liquidity, so with higher volumes we expect to see a smaller percentage of the spread over the asset price. Due to the popularity of certain cryptocurrencies, stocks and other assets, there is high competition between traders who want to make money on the spread.
Bid-ask spread percentage
You need to calculate the spread percentage in order to be able to compare spreads of different cryptocurrencies or assets if necessary. It is calculated using the following formula:
(Ask-price - Bid-price)/Ask-price x 100 = Forward percentage
Let's take BIFI as an example. At the time of writing, BIFI's ask price was US$907 and its bid price was US$901. This difference creates a spread of $6. We divide 6 dollars by 907 dollars, then multiply by 100 and get the spread percentage: approximately 0.66%.
Now let's say the Bitcoin spread is $3, which is half the BIFI spread. But if you compare them as a percentage, the Bitcoin spread is only 0.0083%. BIFI also has lower trading volume, which supports our theory that higher spreads tend to be found in less liquid assets.
Bitcoin's smaller spread leads to a conclusion: assets with a smaller spread percentage tend to be much more liquid. When executing large market orders, the risk of overpayment is minimal.
What is slippage?
Slippage is a common phenomenon in markets with high volatility or low liquidity. Slippage is the phenomenon when a transaction is carried out at a price different from the trader’s expectations.
Let's say you want to place a large market buy order for $100, but the market is not liquid enough to fill your order at that price. As a result, you will have to accept further orders (over $100) until your order is filled. This will result in your average purchase price being above $100. This phenomenon is called slippage.
In other words, when you create a market order, the exchange automatically analyzes it to limit the orders in the order book. The order book will give you the best price, but you will start to expand the order chain if there is not enough volume for the price you want. As a result, the market will fill your order at a price different from what you expected.
Slippage in cryptocurrencies is a common occurrence for automated market makers and decentralized exchanges. The difference may be more than 10% of the expected price due to the unstable or low liquidity of altcoins.
Positive slippage
However, slippage does not always mean a worse price than expected. Positive slippage can occur if market prices fall when you place a buy order or rise when you place a sell order. This is a rare occurrence, but in some volatile markets, positive slippage is still sometimes observed.
Slip resistance
Some exchanges allow you to manually set the slippage resistance level. This feature is present in automated market makers, such as PancakeSwap on Binance Smart Chain and Uniswap from Ethereum.
Depending on the amount of slippage, the execution time of your order may vary. If you set the slippage level to low, the order will take quite a long time to execute, and in some cases it will not be executed at all. If you set the value too high, another trader or bot may beat you.
In this case, a trigger occurs when another trader sets a higher gas fee and buys the asset first. He then creates another trade to sell the asset at the highest price the buyer is willing to pay.
Minimizing negative slippage
Although slippage cannot always be avoided, there are several ways to minimize it.
1. Instead of creating a large order, try breaking it down into smaller blocks. Keep a close eye on your order book: try not to place orders that exceed the available volume.
2. If you are using a decentralized exchange, consider transaction fees. Some networks charge very high fees based on traffic on the blockchain, which can offset any profits you make by avoiding slippage.
3. If you are dealing with assets with low liquidity (for example, 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 ones will affect the price of the next block of your transactions.
4. Use limit orders. They provide a guarantee that you will get the price you want or a better price when trading. And although you will have to sacrifice order execution speed, you will be sure that you will not experience negative slippage.
Summary
When trading cryptocurrency, keep in mind that spread or slippage can change the final price of your trades. It is not always possible to avoid this, but it is important to pay attention to them when making this or that decision. When executing small orders, such phenomena may not be felt as acutely, but the average price per unit of large orders may be much higher than expected.
Understanding slippage is extremely important for decentralized finance traders. Without basic knowledge, you risk losing your money due to front running or negative slippage.
