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EducationalDecember 2, 2021

Bid-Ask Spread and Slippage Explained

Shubham Goyal
Product Specialist
December 2, 2021

The market pricing of crypto assets are closely tied to supply and demand when you buy and sell them on a crypto exchange. Trading volume, market liquidity, and order types are all important factors to consider in addition to the price. You won’t always get the price you want for a trade depending on market conditions and the order types you utilise.

Market participants are always negotiating, resulting in a spread between the two sides (bid-ask spread). Slippage happens based on the amount of an asset you want to trade and its volatility. Getting a rudimentary understanding of an exchange’s order book will go a long way toward avoiding any shocks.

What is Bid-Ask Spread?

The bid-ask spread, simply put, is the difference between an order book’s highest bid and lowest ask prices. Market makers or broker liquidity providers often bring about the Bid-Ask Spread in traditional markets. The spread in crypto markets is determined by the difference between limit orders from market participants.

spread is defined as difference between bid and ask pricesSource: StormGain

Accept the lowest ask price from a vendor if you wish to make an instant market price buy. If you want to sell something right away, you’ll accept the highest bid price from a bidder. The bid-ask spread for higher liquid assets is narrower than low liquid assets, implying that buyers and sellers can execute their orders without generating large price movements. This is the result of a high volume of orders in the order book. A wider bid-ask spread will result in more significant price swings when closing high volume orders.

Bid-Ask Spread and Market Makers

Liquidity is a crucial notion in financial markets. When trading in low-quality markets, o0ne could potentially have to wait hours or even days for another trader to match their order.

It is critical to creating liquidity, but not all markets have enough liquidity from individual traders. Brokers and market makers, for example, supply liquidity in exchange for arbitrage profits in traditional markets.

A trader can profit from a bid-ask spread by purchasing and selling an asset at the same time on a market and can profit from the spread by repeatedly selling at the higher ask price and executing buy orders at the lower bid price. When traded in huge quantities throughout the day, even a modest spread might result in significant profits. As market makers fight and lower the spread, high demand assets start seeing a lower spread.

What is slippage?

In markets with strong volatility or low liquidity, slippage is common. When an order is placed, the exchange tries to match your buy or sell request with the limit orders in the order book, which results in slippage. The order book will make every effort to fill your purchase at the lowest possible cost. If there isn’t enough volume at the price you want, the order book will move up the order chain to the next best price. In the end, your order may execute at a lower-than-expected price.

Your final rate will be different if you decide to buy 1,000 units of an asset now trading at $100 but the exchange doesn’t have enough liquidity to fulfil your order. Until your transaction is completed, you’ll have to accept orders over your bid price of $100. As a result, your average transaction price will be higher than the $100 goal.

Positive Slippage

Slippage doesn’t always imply that you’ll pay more than you intended to. The phenomenon of price drops while you’re placing a buy order or rises while you’re placing a sell order is known as Positive Slippage. Positive slippage is possible in some very volatile markets, albeit it is uncommon.

Negative Slippage

For any trader, negative slippage is a huge problem. Negative slippage occurs when the price of an asset rises after you place a purchase order or falls after you place a sell order.

How To Minimize Slippage

When you’re trying to execute orders rapidly in a fast-paced trading environment, slippage is unavoidable. However, you can reduce negative slippage by doing the following:

Split your orders – Split a large order into smaller parts rather than attempting to execute it all at once. Keep a close eye on the order book to spread out your orders and avoid sending in orders that are too large for the available volume.

Use limit orders – These ensure that you get the buy or ask price you expect – or even better. Limit orders aren’t always quick, and if you set your tolerance threshold too low, you can miss out on some transactions. However, they guarantee that you will not experience any unwanted consequences.

Conclusion

Cryptocurrency trading can be extremely rewarding, but it is not without danger. Aside from the inherent market volatility, the bid-ask spread and slippage both have the potential to cause trading losses. While you may not always be able to avoid these trading charges, it is important to consider them while making trade selections. This is especially true for high-volume trades, where the average price per cryptocurrency may end up being greater or lower than anticipated.

Although financial markets are designed to give traders as many trading options as possible, market participants still decide whether or not slippage happens and how much it affects them. Traders need to pay careful attention to and take liquidity constraints into consideration in order to maximise trading profits.

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