What is bid-ask spread, slippage, and how it plays an impact when you trade in cryptocurrencies.
In the cryptocurrencies industry, the market prices fluctuate due to several factors. Apart from the price of an asset, there are factors like market liquidity, trading volumes, order types and other important aspects to be taken into consideration while trading. Since the market price is affected by these uncontrollable and unpredictable factors, one might not always get the price they want for a trade.
Any trade involves a negotiation between the buyer and the seller. This negotiation creates a spread of prices, which is termed as the ‘Bid-Ask Spread’.
The Basics of Bid-Ask Spread
In order to understand the basics, let’s start with the concept of order data book. An order data book consists of information regarding the underlying supply and demand of any asset in the form of bids and asks, which are eventually executed as trades.
The Bid-Ask Spread is the difference between the highest bid price and the lowest ask price on an order book. In simpler terms, it is the difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept. These prices are quoted as bids and asks on the order book, called ‘Limit Orders’. Depending on the best bid and the best ask, price takers will place a market order to buy or sell an asset in order to earn a profit.
For an example, let’s assume that company X wants to purchase 1,000 shares of Y stock at $10 and there's a seller who wants to sell those 1,000 shares at $11. The spread is the difference between the asking price of $11, and the bid price of $10, which would be $1.
There are several factors that involve in the trade of an asset:
Supply and Demand
The 'supply' refers to the availability of a particular asset in the market, while the 'demand' refers to an individual’s willingness to pay a price for that particular asset. The higher the demand for an asset, the tighter the Bid-Ask Spread will be, since there are more people are willing to trade in that asset.
If there is a significant imbalance or gap in the demand vs. supply, the Bid-Ask Spread will substantially expand.
Liquidity of an Asset
The concept of liquidity is essential to the financial markets. Liquidity indicates the market’s ability to allow assets to trade easily and quickly. An asset with high liquidity has greater chances of a quick and easy trade, as compared to assets with low liquidity. This indicates that assets with high liquidity have a narrower bid-ask spread, which means that there are a higher number of buyers and sellers for that particular asset.
Creating liquidity is important, however individual traders alone cannot create enough liquidity for an asset. Thus brokers and market makers provide liquidity in return for arbitrage profit.
Bid-Ask Spread Percentage Calculation
A Bid-Ask Spread calculation in terms of percentage makes it easier to compare and evaluate different assets and cryptocurrencies.
A Bid-Ask Spread percentage is calculated as follows:
(Ask Price - Bid Price) / Ask Price x 100 = Bid-Ask Spread percentage
Essentially, slippage happens when a trade settles for a different price than requested. Slippage usually occurs in markets when there is low liquidity or high volatility in prices. Whenever you place a market order, an exchange matches your buy or sell request with the limit orders in the order data book. The order data book tries to fulfill your order at the best price, however, if there is an insufficient supply of the asset at your desired price, then the order book will show you the next best price. This leads to slippage, and thus you might have to place an order at a less desirable price.
For instance, you want to place a market order of 1000 units currently trading at $100. If the market does not have enough liquidity to execute your order at $100, the price will go up the order chain. This will cause the average price of your order to be over $100, which is called slippage.
Strategies to Minimize Negative Slippage
1) Break down your order
A smaller order can significantly reduce the possibility of spillage. Instead of placing a large order at once, break it down into multiple small blocks. It’s important to keep an eye on the order book so that you do not end up placing orders larger than the available volumes.
2) Trade in high liquidity and low volatility markets
In a market with high liquidity assets, there are active participants on both sides. This makes it easy to execute the order at your requested price and reduces the chances of slippage. Secondly, high volatility markets may lead to unexpected price fluctuations, hence it’s best to trade in a market that has less volatility and risk.
3) Use limit orders
Limit orders may not be fast, but they can definitely help in minimizing spillage. Limit orders ensure that you get the requested price or better while trading. Hence, even if the speed of your market order reduces, you will not experience negative spillage.
However, slippage is not always negative. In highly volatile markets, one may experience positive spillage, which means that the price of an asset reduces while you are making an order. If this occurs, then you will have a better price while buying or selling your order.
In conclusion, Bid-Ask Spreads and Slippage have a major impact on the price of your order. Trading in cryptocurrency has its degree of risks, however, it can be an extremely rewarding market too. Hence, it’s important to do thorough research and keep the concept of Bid-Ask Spread and Slippage in mind while making decisions.