What Is Bid-Ask Spread and Slippage?
When trading in the cryptocurrency market, understanding your costs is crucial for optimizing strategies and maximizing your potential profits. Ever wondered why the market price you see isn't always the execution price you get? Or why do your buy orders sometimes fail even when you seem to have enough money in your account?
The reason is bid-ask spread and slippage. Spread and slippage are essential concepts that every crypto trader needs to understand. They can make up anywhere from 0.01% to even 10% of your trading costs, depending on the cryptocurrency you are trading. By grasping these dynamics and learning to work around them, you'll be better equipped to make informed decisions around your trades. Let's dive into the details and uncover the secrets behind these hidden costs.
What Is a Bid-Ask Spread?
The bid-ask spread represents the difference between the highest price a buyer is willing to pay (bid price) and the lowest price a seller is willing to accept (ask price) for a particular cryptocurrency. This discrepancy reflects the ongoing negotiation between market participants and the underlying supply and demand dynamics for that specific asset.
The negotiation happens on exchanges through an order book. The order book is a real-time list of buy and sell orders for a particular cryptocurrency. The highest bid price sits at the top of the buy side, while the lowest ask price sits at the top of the sell side. The difference between these two is your spread.
How to Calculate Bid-Ask Spread?
Calculating the spread is straightforward:
Spread = Lowest Ask Price - Highest Bid Price
For example, if the lowest ask price for Bitcoin is $30,050 and the highest bid price is $30,000, the spread is $50.
You can also express the spread as a percentage of the ask price:
Bid-Ask Spread Percentage = (Spread / Lowest Ask Price) * 100
In the above example, the bid-ask spread in percentage terms would be 0.17%.
Why Does the Spread Matter?
The bid-ask spread plays a crucial role in trading, serving as a hidden transaction cost and a marker of market liquidity. Narrow spreads usually indicate a liquid market with active trading, while wider spreads suggest lower liquidity and higher trading costs:
Transaction Costs: The spread represents a hidden cost of trading. When you buy at the ask price, you're essentially paying a premium above the asset's "true" market value. When you sell at the bid price, you're receiving slightly less than the "true" value.
Market Liquidity: The size of the spread is often an indicator ofliquidity and trading volume. In highly liquid markets with many buyers and sellers, spreads tend to be narrow. However, in less liquid markets, there will be wider bid-ask spreads, meaning higher transaction costs.
The Role of Market Makers
Market makers play a crucial role in maintaining liquidity in the crypto market. They continuously provide both buy and sell orders, narrowing the bid-ask spread and ensuring that traders can execute their orders smoothly.
How to Incorporate Spread into Your Trading Strategy?
The bid-ask spread, while seemingly small, can impact your trading outcomes, especially when dealing with large ordersor in volatile markets. Here's how to factor it in for both long and short positions:
Going Long
When entering a long position, your buy order is executed at the lowest ask price. This means the market price you see on the chart (the highest bid price) is not the price you'll actually pay. To ensure your order is filled when the market reaches your desired entry point, you need to add the spread to your buy order.
Going Short
Conversely, when entering a short position, your sell order is executed at the highest bid price (the market price you see on the chart).
But when you exit a short position, your buy order is executed at the lowest ask price, which includes the spread. This means you'll need the price to drop further than your initial target to cover the spread and achieve your desired profit.
Factoring in the Spread
Let's say you want to buy 50 Dogecoin (DOGE) when its market price reaches $0.07, and the spread is $0.001. To ensure your order is filled, you should place a limit buy order at $0.071 (the ask price).
If you were to go short on DOGE at the same price with the same spread, you would place a limit sell order at $0.069 (the bid price).
The Bottom Line
By understanding how the bid-ask spread affects your entry and exit prices, you can:
Avoid missing out on trade opportunities due to incorrectly placed orders.
Set realistic profit targets and stop-loss orders that account for the spread.
Choose trading pairs with tighter spreads (higher liquidity and trading volume) to minimize trading costs.
What Is Slippage?
Slippage occurs when a trade is executed at a different price than the expected price, and is a common occurrence in volatile markets or when trading assets with low liquidity and trading volume. It can result from rapid price movement between the time you place an order and when it's filled.
What Is the Difference Between Slippage and Bid-Ask Spreads?
While both impact the final price you pay or receive in a trade, they have distinct characteristics:
Bid-Ask Spread:
Definition: The difference between the highest bid price (what buyers are willing to pay) and the lowest ask price (what sellers are willing to accept).
Visibility: A constant, visible gap on the order book.
Impact: Represents the immediate cost of executing a market order due to the difference in buy and sell prices.
Influenced by: Liquidity and trading volume (tighter spreads in liquid markets), and
market maker activity.
Example: If Bitcoin's bid price is $29,950 and the ask price is $30,000, the spread is $50. A market buy order would execute at $30,000, and a market sell order would execute at $29,950.
Slippage:
Definition: The difference between the expected price and the execution price of a trade.
Visibility: Not always visible beforehand; occurs during trade execution.
Influenced by: Market volatility, liquidity, order size (large orders are prone to slippage), order type (market orders are more susceptible to slippage).
Example: You place a buy order for Ethereum at $1,800, but due to a sudden price surge, it executes at $1,810, resulting in negative slippage.
Key Takeaway: Think of the bid-ask spread as the known cost of entering the market, while slippage is an unpredictable factor that can arise when you execute the trade, especially in fast-moving or illiquid markets. Understanding both is crucial for managing your trading costs and making informed decisions in the crypto market.
How Does Slippage Work?
Slippage often occurs when using market orders, which are executed immediately at the best available market price. If there isn't enough liquidity to fill your order at the expected price, or if the market experiences sudden volatility, your order might be filled at different price levels, resulting in slippage.
Factors that Can Cause Slippage
Slippage is primarily caused by two factors:
Market Volatility: In highly volatile markets, prices can change rapidly, even within seconds. When you place a market order, it's executed immediately at the best available market price. If the pricechanges significantly between the time you place the order and the time it's filled, slippage occurs.
Liquidity and Trading Volume: Low liquidity means there aren't enough buyers and sellers to absorb large orders at a specific price level. When you place a large buy order
, for example, you might consume all the available liquidity at the lowest ask price. To fill the rest of your order, the exchange has to move up the order book, resulting in higher prices and negative slippage.
The type of order you use can also affect your susceptibility to slippage:
Market Orders: These orders are executed immediately at the current market price
, making them highly vulnerable to slippage, especially in volatile or illiquid markets.
Limit Orders: Limit orders allow you to specify the maximum price you're willing to buy or the minimum price you're willing to sell. While they offer more control over your execution price, they might not be filled if the market doesn't reach your desired price level.
Slippage Tolerance
Some exchanges and decentralized platforms allow you to set a slippage tolerance. This means you can specify the maximum percentage deviation you're willing to accept from your expected price. If the market price moves beyond your tolerance before your buy order is filled, the order will be canceled.
Learn how to set your max slippage in the Flipster app.
How to Minimize Slippage?
While positive or negative slippage is an inherent part of trading, proactive strategies can help you minimize its impact. Here are some approaches to consider:
Prioritize Liquid Markets
The golden rule of minimizing negative slippage is to trade in liquid markets with high trading volume. These markets typically have tighter bid-ask spreads, meaning less room for price movement between the time you place a buy order and when it's filled.
How to Identify Liquid Markets:
High 24-hour Trading Volume: Look for cryptocurrencies with high 24-hour trading volume. High levels of market activity ensure ample liquidity and lowers the risk of slippage. At the same time, check the historical trading volumes of a cryptocurrency to ensure consistent liquidity. Spikes in volume can be misleading if not part of a sustained trend.
Depth of Order Book: Check the order book for depth and a large number of active buyers and sellers. A deep order book with orders at various price levels close to the current market price is a reliable indication of high liquidity.
Use Limit Orders
Limit orders are your shield against unexpected negative slippage. Unlike market orders, which execute immediately at the prevailing market price, limit orders allow you to specify the exact price at which you're willing to buy or sell.
By setting a limit order, you gain more control over your execution price and eliminate the risk of negative slippagecaused by sudden price movements. However, be aware that if the market doesn't reach your specified price, your order may not be filled.
Time Your Trades Wisely
Market volatility often follows a cyclical pattern. Trading during periods of high volume and lower volatility can reduce the risk of negative slippage, which typically involves trading during peak hours when more traders are active in the market.
Avoid placing large orders during periods of high volatility or thin liquidity, as this increases the likelihood of negative slippage.
Break Down Large Orders
If you need to execute a large order, it's often advisable to break it down into smaller buy orders and execute them gradually. This reduces the chance of your order consuming all the available liquidity at a particular price level, thus preventing drastic price movements and subsequent slippage.
Choose Your Trading Platform Wisely
The exchange you choose can impact your slippage experience. These platforms often partner with or incentivize market makers to provide liquidity, ensuring there's always sufficient trading volume and activity to minimize slippage. Opt for platforms like Flipster, which has partnered with a professional designated market maker, and are known for their tight spreads, narrow slippage, high liquidity, and fast order execution. Download the Flipster app (Android or Apple) to get started.
Additional Tips:
Use Stop-Loss Orders:Even with these precautions, slippage can still occur in extremely volatile conditions. Setting stop-loss orders can protect you from excessive losses if the market moves unexpectedly against you.
Monitor the Order Book: Keep an eye on the order book to gauge the depth of the market and potential price levels where slippage might occur.
Be Patient: Don't rush into trades, especially in illiquid markets. Take your time, assess the situation, and execute your orders strategically.
Disclaimer: This material is for information purposes only and does not constitute financial advice. Flipster makes no recommendations or guarantees in respect of any digital asset, product, or service. Trading digital assets and digital asset derivatives comes with significant risk of loss due to its high price volatility, and is not suitable for all investors.