Bid-offer spread and slippage explanation — Kolin Lukas “BA” | By Colin Lukas | The Capital | June 2021
Slippage is common in high volatility or low liquidity markets. Slippage occurs when the transaction is settled at a different price than expected or required.
For example, suppose you want to place a big market buy order at a price of $100, but the market does not have the necessary liquidity to execute your order at that price. Therefore, you will have to accept the following orders (above $100) until all your orders are filled. This will cause the average price of your purchase to be higher than $100, which is what we call slippage.
In other words, when you create a market order, the exchange will automatically match your purchases or sales to limit the orders on the order book. The order book will match you with the best price, but if the quantity is not enough to meet the price you need, you will start to go further in the order chain. This process causes the market to fill your order at unexpectedly different prices.
In cryptocurrencies, slippage is common in automated market makers and decentralized exchanges. For unstable or low-liquidity altcoins, the slippage may exceed 10% of the expected price.
Slippage does not necessarily mean that you will end up with a worse price than expected. If the price drops when you place a buy order or the price rises when you place a sell order, a positive slippage may occur. Although not common, positive slippage may occur in some highly volatile markets.
Some exchanges allow you to manually set the slippage tolerance level to limit any slippage you may encounter. You will see this option in automated market makers, such as PancakeSwap on Binance Smart Chain and Uniswap on Ethereum.
The amount of slippage you set will have a ripple effect on the time required for your order to be cleared. If you set the slippage to a low level, it may take a long time for your order to be traded or not traded at all. If you set it too high, other traders or robots may see your pending orders and preempt you.
In this case, when another trader sets a higher gas fee than you purchase the asset first, a preemptive transaction will occur. Then the leader enters another transaction and sells it to you at the highest price you are willing to accept based on your slippage tolerance.
Although you cannot always avoid slippage, you can use some strategies to minimize slippage.
- Instead of placing a large order, try to break it down into smaller pieces. Pay close attention to the order book to spread your orders and make sure not to place orders larger than the available quantity.
2. If you use a decentralized exchange, please don’t forget to consider transaction fees. Some networks charge high fees based on blockchain traffic, which may offset any gains you get and avoid slippage.
3. If you deal with less liquid assets, such as small liquidity pools, your trading activities may significantly affect the price of the asset. A single transaction may have a small amount of slippage, but a large number of smaller slippages will affect the price of the next trading block you make.
4. Use limit orders. These orders can ensure that you get the price you want or a better price when trading. When you sacrifice the speed of a market order, you can ensure that you will not encounter any negative slippage.
When you trade cryptocurrency, don’t forget that the bid-ask spread or slippage will change the final price of your transaction. You can’t always avoid them, but it’s worth considering your decision. For smaller transactions, this may be small, but keep in mind that for large-volume orders, the average price per unit may be higher than expected.
For anyone trying to decentralize finance, understanding slippage is an important part of the trading foundation. Without some basic knowledge, you are likely to lose money due to early trading or excessive slippage.