Bid-ask spread is the difference between the lowest price asked for an asset and the highest price bid. Liquid assets like Bitcoin have a smaller spread than assets with less liquidity and trading volume.
Slippage occurs when a trade settles for an average price that is different than what was initially requested. It often happens when executing market orders. If there's not enough liquidity to complete your order or the market is volatile, the final order price may change. To combat slippage with low-liquidity assets, you can try to split your order into smaller parts.
When you buy and sell assets on a crypto exchange, the market prices are directly related to supply and demand. Apart from the price, other important factors to consider are trading volume, market liquidity, and order types. Depending on the market conditions and the order types you use, you won't 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 sides (bid-ask spread). Depending on the amount of an asset you want to trade and its volatility, you might also encounter slippage (more on this later). So to avoid any surprises, getting some basic knowledge of an exchange's order book will go a long way.
What is bid-ask spread?
Market makers and bid-ask spread
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 return 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 higher ask price and buying at the lower bid price over and over, market makers can take the spread as arbitrage profit. Even a small spread can provide significant profits if traded in a large quantity all day. Assets in high demand have smaller spreads as market makers compete and narrow the spread.
Depth charts and bid-ask spread
As we mentioned before, there is an implied relationship between liquidity and smaller bid-ask spreads. Trading volume is a commonly used indicator of liquidity, so we expect to see higher volumes with smaller bid-ask spreads as a percentage of an asset's price. Heavily traded cryptocurrencies, stocks, and other assets have much more competition between 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 = BidAsk Spread Percentage
Let's take BIFI as an example. At the time of writing, BIFI had an ask price of $907 and a bid price of $901. This difference gives us a bid-ask spread of $6. $6 divided by $907, then multiplied by 100, gives us a final bid-ask spread percentage of roughly 0.66%.
Now suppose that Bitcoin has a bid-ask spread of $3. While it’s 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 a significantly lower trading volume, which supports our theory that less liquid assets tend to have larger bid-ask spreads.
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 expected or requested.
For example, suppose you want to place a large market buy order at $100, but the market doesn't have the necessary liquidity to fill your order at that price. As a result, you will have to take the following orders (above $100) until your order is filled entirely. This will cause the average price of your purchase to be higher than $100, and that’s what we call slippage.
In other words, when you create a market order, an exchange matches your purchase or sale automatically to limit orders on the order book. The order book will match you with the best price, but you will start going further up the order chain if there’s an insufficient volume for your desired price. This process results in the market filling your order at unexpected, different prices.
Slippage doesn’t necessarily mean that you’ll end up with a worse price than expected. Positive slippage can occur if the price decreases while you make your buy order or increases if you make a sell order. Although uncommon, positive slippage may occur in some highly volatile markets.
The amount of slippage you set can have a knock-on effect on the time it takes your order to clear. If you set the slippage low, your order may take a long time to fill or not fill at all. If you set it too high, another trader or bot may see your pending order and front-run you.
In this case, front running happens when another trader sets a higher gas fee than you to purchase the asset first. The front runner then inputs another trade to sell it to you at the highest price you are willing to take based on your slippage tolerance.
Minimizing negative slippage
While you can't always avoid slippage, there are some strategies you can use to try to minimize it.
1. Instead of making a large order, try to break it down into smaller blocks. Keep a close eye on the order book to spread out your orders, making sure not to place orders that are larger than the available volume.
2. If you're using a decentralized exchange, don't forget to factor in transaction fees. Some networks have hefty fees depending on the blockchain's traffic that may negate any gains you make, avoiding slippage.
When you trade cryptocurrency, 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 factoring into your decisions. For smaller trades, this can be minimal but remember that with large volume orders, the average price per unit might be higher than expected.
For anyone experimenting with decentralized finance, understanding slippage is an important part of the trading basics. Without some basic knowledge, you run a high risk of losing your money in front-running or excessive slippage.