Bid-Ask Spread and Slippage: An Explanation for a Beginner

Introduction

When you buy and sell cryptocurrencies on an exchange, you think that you can buy and sell whenever you want and at whatever price you desire. But there is a lot more to it when you study about the process. There are sellers as well as buyers in the market. The highest price a buyer is ready to pay is called the bid price. The lowest price a seller is ready to settle at is called the ask price.

What is Bid-Ask Spread?

The bid-ask spread is actually a gap between the highest bid price and the lowest ask price. The prices are determined mainly by the supply and demand. Besides price, consider trading volume, which shows how actively a coin is traded, and market liquidity, which affects how easily you can buy or sell without moving the price. Order types matter too: market orders execute immediately at the best price available, while limit orders let you set your price but may not fill right away. These factors all impact your trading outcome.

Bid-Ask Arbitrage

Not just a coin, the whole market responds to the liquidity factor. High-liquidity markets like forex are harder to manipulate than the crypto market. Inside the cryptocurrency market, high-liquidity assets like $BTC are lucrative for traders who extract arbitrage profit. Arbitrage trading is of two types. Sometimes, traders take advantage of minor price differences on different exchanges. Also, the bid-ask spread can be utilized to make trades again and gain throughout the day. Though the spread is usually very small, large investment with high frequency trading can earn handsome profits.

To understand the bid-ask spread arbitrage trading, take an example of a trader who has simultaneous orders placed to buy at a lower price and sell higher. They buy $ETH at $3900 and sell at $3901. When they do it repeatedly, they earn significant profits.

Calculating Bid-Ask Spread and Its Percentage

Although you can directly view the values on many exchanges, it is possible to calculate the percentage of the bid-ask spread for yourself. For this, you need to have a detailed overview of the order book to know the best bid price (what is the highest price a buyer is offering), and the best ask price (what is the lowest price a seller is willing to accept.) You can find out the bid-ask spread by subtracting the best bid price from the best ask price.

Bid-Ask Spread = Best Ask Price – Best Bid Price

Similarly, the percentage can be obtained by dividing the spread value by the best ask price and multiplying the answer by 100.

Bid-Ask Spread Percentage = (Bid-Ask Spread / Best Ask Price) X 100

Suppose a trader wants to do bid-ask arbitrage trading by exploiting the spread in the price of $SOL. They notice that the best bid price is $199.80, and the best ask price is $200.

Bid-Ask Spread = $200 – $199.80 = $0.20

Bid-Ask Spread Percentage = ($0.20 / $200) X 100 = 0.1%

Solana is one of the top-ranked coins, so it is bound to have a very low bid-ask spread percentage. Low-cap coins usually have very low liquidity, and consequently, relatively high bid-ask percentage. The lower the percentage the less risky a coin is and vice versa.

What is Slippage?

Slippage is the filling of an order at a price different from what you want. For example, you observe that market is undergoing correction and there are opportunities inviting you to buy the dip, you set a limit order to buy $LINK at $12 when it is trading at $14. However, when you open the exchange after a while, you see that the buy order was filled at $12.5, but it is trading at $11. This is obviously very disturbing for you because your calculation of the profit has been disrupted badly.

When you place a market order, the exchange instantly matches it with the best available prices in the order book. If there isn’t enough volume at that price, your order moves to the next best prices, which can cause parts of it to be filled at higher or lower prices than you expected.

Why Slippage Occurs

Among many others, the most significant reason behind slippage is low liquidity. When there are enough buy and sell orders, it is difficult for manipulators to destabilize the price. On the other hand, even small retailers can bring price swings when there is shortage of orders and liquidity.

Positive Slippage

In contrast to the negative slippage that reduces your profit or increases your losses, there can also be positive slippage, which can make you earn profit more than your calculation, or incur loss less than you feared. Despite being extremely rare, it can happen when volatility is higher than usual.

Limiting the Slippage Factor

A few decentralized exchanges allow you to set a limit on the extent of slippage you are ready to tolerate. It can save you from losses, but it also has a downside: your orders may take longer to fill, or they may not fill at all. Also, other traders can front run you by looking at your order on the order book. They may buy the coin first and then ask you to buy it at a price higher than you expected.

How to Minimize Negative Slippage

You can reduce the risks involved in being affected by negative slippage. First of all, you can break your order into many small orders. Even when the liquidity is low, small orders are likely to get filled at the desired prices.

On decentralized exchanges, you must consider slippage that might happen due to unreasonably high trading fees. For example, the trading fee at your ask price or bid price may reduce your profits.

In the next place, try to avoid low-cap coins as much as possible because due to their small market cap, even a minnow can cause wild price swings.

Conclusion

In brief, bid-ask spread is the gap that may exist between the best ask price and the best bid price. This gap is exploited by the traders to make high frequency trading and earn safe profits from stable price action of high-cap cryptocurrencies. High liquidity helps keep prices stable, but low liquidity can destabilize the price. Slippage is filling of your order at an undesired price, and it is also a result of low liquidity. You can avoid negative slippage by breaking your orders in small chunks and avoiding low-cap coins.

Frequently Asked Questions

What is the bid-ask spread in crypto trading?

It is the gap between the highest bid price (what a buyer is ready to pay) and the lowest ask price (what a seller is willing to accept).

What causes slippage?

The most significant reason behind slippage is low liquidity, where even small retailers can bring price swings due to a shortage of orders.

How can I minimize negative slippage?

Break your order into many small orders and avoid low-cap coins, as they can experience wild price swings.

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