Market prices vary due to a number of factors while trading on crypto exchanges. In addition to the price of an asset, trading volume, market liquidity, and order types are important factors to consider while trading. Because of these multiple factors, you might not always get the price you want for trade.

The negotiation between buyers and sellers of the trade creates a spread of prices which is called the ‘bid-ask spread’. It is helpful to understand an exchange's bid-ask spread and order book to counter the unexpected changes in prices.

What is a Bid-Ask Spread?

Bid-ask spread is the difference between the highest ‘bid’ price and the lowest ‘ask’ price for an asset. This is not unique to crypto markets - market makers and broker liquidity providers create a bid-ask spread in traditional markets. In crypto markets, the spread is a result of the difference between buyers’ limit orders and sellers’ limit orders.

The higher the liquidity of an asset, the smaller the bid-ask spread will be. More liquid assets generally have a large volume of orders and a small bid-ask spread. If an asset has a wider bid-ask spread, then there will be considerable price fluctuations when closing large volume orders. You need to take the lowest ask price from a seller while making an instant market price purchase. If you want to make an instant sale, it is important to consider the highest bid price from a buyer.

Market makers and bid-ask spread

Asset liquidity plays an important role in financial markets. Low-liquidity markets may find you waiting for a long time to match your order with another trader. Liquidity is the market’s ability to allow assets to trade quickly and easily. Creating liquidity is essential but markets cannot have enough liquidity from individual traders alone.

Brokers and market makers provide liquidity in traditional markets for arbitrage profits. Market makers leverage the bid-ask spread by buying and selling an asset simultaneously. They buy the asset at a lower bid price and sell it at the higher ask price over and over, and take the bid-ask spread as arbitrage profit.

If the spread is small, then it will provide substantial profits when traded in large quantities throughout the day. Assets in high demand have smaller spreads because market makers compete and narrow down the spread.

Depth charts and bid-ask spread

To understand the relationship between trading volume, liquidity, and the bid-ask spread, look at some real-world exchanges. By selecting the depth chart view in exchange platforms, you can easily look at the bid-ask spread.

The depth option on crypto exchanges shows a graphical representation of an asset’s order book. The quantity and price of bids are shown in green and the quantity and price of ask are shown in red. Bid-ask spread is the gap between these two areas. By subtracting the green bid price from the red ask price, we can calculate the bid-ask spread.

Bid-ask spread percentage

Evaluating a bid-ask spread in percentage terms makes it easy for us to compare different assets or cryptocurrencies. A bid-ask spread percentage can be calculated as,

(Ask price - Bid price)/Ask price * 100 = Bid-ask spread percentage

Assets with a narrower bid-ask spread percentage are likely to be more liquid. While executing large market orders, if you select an asset with a narrower bid-ask spread percentage, there will be less risk of having to pay unexpected prices.

What is Slippage?

Slippage generally happens when a trade settles for a different price than requested. The price can be higher or lower than the expected price. Slippage usually occurs in high volatility and low liquidity markets.

Let’s assume that you want to place a large market buy order at $100, but the market doesn’t have the required liquidity to fill your order at $100. As a result, you have to take the following orders above $100 until your order is filled. In this case, the average price of your purchase will be higher than $100. This is known as “slippage”.

When you create a market order, an exchange tries to match your order automatically to limit orders on the order book. The order book will match your order with the best price. If there is an insufficient volume of your desired price, the price will start to go up the order chain. The whole process results in the market filling your order at unexpected prices (higher or lower).

Slippage is a common occurrence in decentralized exchanges and automated market makers. Sometimes, slippage can be over 10% of the expected or requested price for volatile or low liquidity cryptocurrencies.

Positive slippage

Slippage doesn’t always make you end up with a worse price than expected. In highly volatile markets, positive slippage will occur when the price decreases while you are making an order. If positive slippage occurs, you will have a better price while buying or selling than requested.

Slippage tolerance

You will find an option to set a slippage tolerance in some exchanges. This option enables you to limit any slippage you might experience while trading.

If you set your slippage tolerance low, it might take a long time to fill. If you set it too high, another trader or bot may front-run you by seeing your pending order. Front-runners usually set a higher fee to purchase the asset first. Then they sell it to you at the highest price you are willing to take based on your slippage tolerance.

Strategies to minimize negative slippage

It isn’t possible to avoid negative slippage completely. However, the following strategies will help you to minimize it.

  • Break down your large order into smaller blocks. Observe the order book and spread out your orders. This will make sure that you do not take orders larger than the available volume.
  • If you are using any decentralized exchange, factor in transaction fees. Some networks have bulky fees based on the blockchain’s traffic to avoid slippage.
  • Trade low volatility and high liquidity markets. High-liquid markets will have active participants on both sides and make it easy to execute the order at the requested price. High volatility causes price changes, and you might end up with unexpected prices.
  • By using limit orders, you can minimize negative slippage. Limit orders make sure you get the requested price while trading. You will not experience negative slippage if you sacrifice the speed of your market order.

Bottom Line

Bid-ask spread and slippage have the ability to change the final price of your order. It might be impossible to avoid them completely, but it is worth considering them while making decisions. For small trades, the impact can be minimal, but for large volume trades, the average price might be higher or lower than expected.