Spreads and Slippage: real costs to trading
Description
Bid-ask spread or slippage is one of the basic terms you should know when trading crypto. Learn about everything from our article.
Understanding Liquidity
The concept of "liquidity", if translated from the Latin language, means "fluid". It means the property of an asset is promptly sold at a value that is as close as possible to the market price on the market.
Alternatively, liquidity measures a trader's ability to buy or sell a crypto asset without significantly changing its value. A coin, a token with high liquidity, is always bought and sold quickly because there are many buyers and sellers.
At the same time, because the number of buyers and sellers is high, the so-called spread between supply and demand narrows. It is considered an important indicator of liquidity. The smaller the spread between supply and demand, the higher the liquidity of the cryptocurrency.
If the liquidity of an asset is low, it indicates a high probability of sharp price spikes and so-called slippage.
How Liquidity Can Affect Traders and Brokers
As stated earlier, if liquidity is low, the price of an asset becomes more volatile—accordingly, slippage and value manipulation increase.
Because of low liquidity, traders and brokers must wait longer for the favorable moment and risk losing profits. Experienced traders and brokers know how liquidity can affect their trades. That's why they develop strategies for selecting assets with high liquidity.
What is bid-ask spread?
The stock market abounds with many specific concepts and definitions. Among them is often found such as the bid-ask spread. What is it?
According to the classic definition, the Bid-Ask spread is the difference between the highest value of the Bid and the lowest value of the Ask book of orders.
What is a spread in trading? The spread in trading on exchanges is simply the difference between the best bid and ask prices of trading assets.
Types of spreads
There are different types of spreads in the market at the moment. A particular spread is used for a particular trade. Most often, they are created by market makers or liquidity brokers. And what is spread in cryptocurrency trading? In the cryptocurrency market, the spread is the result of the difference between the buyer's and seller's limit order. There are several types of spreads in the market, like:
- Quoted.
- Efficient
- Realized.
Quoted spread
The quote spread is an indicator representing the difference between an asset's purchase price and the selling price of the asset on the trading floor.
Effective spread
The quoted spread often exceeds the spreads paid by the trader due to price softening, i.e., when a dealer offers a more favorable price than the quoted one. Efficient spreads are more difficult to measure than quoted ones because it is necessary to compare the real deal with the quote, consider some reporting delays, and so on.
Realized spread
It includes a loss for a trader and the cost of transactions made by intermediaries. In turn, the realized spread carries out the isolation of the cost of urgency, known as the "real cost."
The Bid-Ask Spread's Relation to Liquidity
The size of the spread between the bid-ask spread from one asset to another is differentiated by the difference in liquidity of the assets.
For example, cryptocurrency is considered the most liquid asset, and the spread between the bid and ask in the currency markets is the smallest, that is, it can be measured in fractions of a cent. At the same time, such a spread parameter as width often depends on both liquidity and how quickly the value of the currency changes during the trading session.
Spread on EXEX: Example
What factors influence the spread? Most often, these are general financial indicators for trading the selected asset: its liquidity, market volatility, transaction amount, and even the time of business activity. It is more profitable for traders to buy assets with a minimum spread. The spread is usually calculated as a percentage, and the smaller the percentage, the better. Let's look at an example.
At the time of writing this article, Bitcoin's ask price is $30,907, and its bid price is $30,901. This difference creates a spread of $6. We divide $6 by $30,907, then multiply by $100 and get the spread percentage: approximately 0.0194%.
A spread of less than 0.01% is considered excellent. The EXEX exchange supports this value.
What is slippage?
Slippage definition: represents the difference between the value at which a cryptocurrency asset is expected to be bought or sold and the real value at which the trade is then conducted.
It may be noted that for traders, slippage is considered a very significant indicator, as it directly affects their profits. The risk of slippage can lead to potential losses, especially if the order size is large. Slippage risk is especially noticeable during periods of volatility in the stock and cryptocurrency markets.
However, at the same time, a tiny percentage of traders can use slippage to grow their own portfolios. After all, similar to the risks, high profits from such a transaction are likely. However, these cases are more related to luck rather than serious market analysis.
In crypto, slippage is not unusual on centralized and decentralized platforms. The concept of slippage is also used in the decentralized finance market. DeFi slippage is the difference in value between when a transfer is sent and when the transfer is confirmed on the blockchain network. It can be more than ten percent of the estimated value of a volatile altcoin.
How Slippage Happens
Slippage is quite common in the marketplace. As we said earlier, it is especially true for altcoins, which are low-liquid. Slippage often happens when a trade is made at a value different than expected or requested.
Slippage occurs when an order is created in the market. The trading floor then matches the buy or sell request against the limit order. In turn, the order book will try to execute the order at the most favorable value. However, if there is insufficient volume in terms of value, then the order book will climb up the order chain to the next best value.
For example, a trader places an order to buy at $200. However, the market does not yet have the necessary liquidity to execute the order at the above value. As a result, the trader has to accept the order above $200 until his order is filled.
How to protect your EXEX account from slippage
EXEX Exchange helps you avoid the consequences of slippage by using limit orders. A trader can use this tool to protect his trading position. Place limit orders while trading and be insured against price slippage and unjustified liquidation of a trade.
Positive Slippage
It is worth noting that slippage cannot be considered exclusively negative. Positive slippage is formed when an order to buy is placed, and the asset's price decreases. The final execution price is lower than expected for your market buy order.
A similar positive slippage occurs when you place a sell order, and the price rises. If the final strike price is better than expected, your positive slippage actually results in a better trade for you.
Negative Slippage
Negative slippage is a serious problem for any trader working in the markets. If the price of an asset increases after placing a buy order or decreases after placing a sell order, it is highly likely that the trader will experience negative slippage. That's why developing your own trading strategy responsibly is so important.
This is especially true for novice traders who are just starting out in the cryptocurrency or stock markets. Very often, in the pursuit of maximum profit, they do not consider the current trends on the trading floors and, as a result, suffer significant losses even during one trading session.
Slippage tolerance
Every trader and investor has their own level of slippage tolerance. If it is insufficient, it should be taken into account, especially if he trades at the peak time for the market. Eventually, slippage tolerance is determined by a market participant's psychological qualities, risk tolerance, and adventurism. Low tolerance to slippage is characteristic of beginner traders.
How to Minimize Slippage
Slippage is inevitable during fast trading when a trader is trying to execute an order quickly. However, it is possible to minimize negative slippage if certain actions are taken.
In particular, it is possible to divide orders. To avoid trying to execute 1 large order at once, it can be broken into several smaller parts. You need to keep an eye on the order book to distribute orders correctly and avoid placing orders larger than the available volumes allow.
It is also possible to use limit orders. This way, it is guaranteed that the trader or broker will receive the expected value of buying or selling. It should be noted that a limit order is often executed slowly. Therefore, there is a chance of missing the cashing of some transactions if a very low tolerance level is set. But they ensure that the market participant will not suffer from negative slippage.
Some cryptocurrency exchanges actually display slippage warnings if a customer enters an order with a percentage of slippage above a certain amount, usually 2% or higher.
Moreover, most exchanges allow you to adjust the slippage tolerance, which is a percentage. This percentage can be changed depending on the transaction to ensure the execution of the order.
Slippage Tolerance
Every trader and investor has their own level of slippage tolerance. If it is insufficient, it should be taken into account, especially if he trades at the peak time for the market. Eventually, slippage tolerance is determined by a market participant's psychological qualities, risk tolerance, and adventurism. Low tolerance to slippage is characteristic of beginner traders.
How to minimize slippage
Slippage is inevitable during fast trading when a trader is trying to execute an order quickly. However, it is possible to minimize negative slippage if certain actions are taken.
In particular, it is possible to divide orders. To avoid trying to execute 1 large order at once, it can be broken into several smaller parts. You need to keep an eye on the order book to distribute orders correctly and avoid placing orders larger than the available volumes allow.
It is also possible to use limit orders. This way, it is guaranteed that the trader or broker will receive the expected value of buying or selling. It should be noted that a limit order is often executed slowly. Therefore, there is a chance of missing the cashing of some transactions if a very low tolerance level is set. But they ensure that the market participant will not suffer from negative slippage.
Some cryptocurrency exchanges actually display slippage warnings if a customer enters an order with a percentage of slippage above a certain amount, usually 2% or higher.
Moreover, most exchanges allow you to adjust the slippage tolerance, which is a percentage. This percentage can be changed depending on the transaction to ensure the execution of the order.
Conclusion
As you know, trading cryptocurrencies can be very profitable but also comes with risks. In addition to the market's inherent volatility, there is also the possibility of trading losses due to spread and slippage. While it is always possible to avoid these trading costs, it is worth considering them when making trading decisions.
This is especially true for large trades, where the average price for a cryptocurrency may be higher or lower than expected. It is important to choose the right time to trade. Also, take time to develop your own spread strategies and carefully study fundamental and technical analysis to minimize your risks.
Financial markets are structured to give traders as many trading options as possible, but market participants still determine whether slippage occurs and its ultimate impact. Informed traders pay close attention to liquidity constraints to maximize trading profits.
Spread trading, like any trading in the cryptocurrency or stock markets, requires traders and investors to have deep knowledge, sound risk assessment, and intuition.