By Nathan Ferguson
When you are trying to buy or sell an asset on a crypto exchange, one of the things you must be aware of is that the market prices are affected by the demand and supply of the asset in the market. However, beyond the price, some other underlying factors affect the process, like the trading volume, order types, and market liquidity. Depending on the type of order you filed and the current market condition, you will not always get the accurate price you want to trade at.
In the market, there is a constant and consistent negotiation between buyers and sellers that create what is called a Spread between the two parties (often called Bid-Ask Spread). Depending on the volume of asset you are trying to trade, there is also a phenomenon in crypto trading called Slippage, and it is always essential to get the basic knowledge of how the order book of exchange works to avoid surprises. Hence the reason and objective of this guide.
What separates experienced traders from newbies in the crypto space (as it is everywhere) is the amount of knowledge they have acquired about the space. This guide will attempt to demystify the common terms involved in active crypto trading to give investors and retail traders the required basic knowledge for their safety in the market. this guide will open you to the fundamentals of slippage, spread, liquidity, and other related concepts involved in crypto trading.
Understanding Liquidity in Crypto Trading
Liquidity is the metric used to measure how easily an asset can be traded and exchanged in a particular market without causing a huge or significant impact on the market value of the asset. In other words, the willingness of people to buy and sell an asset shows how liquid the market asset is. A token or coin is considered to have strong liquidity when it has many buyers and sellers and the order book that record pending orders is deep.
Liquidity is one factor that affects the buy-ask spread of a token because the abundance of sellers and buyers in a particular market narrows the spread. You can also say the buy-ask spread is a good measure of the asset’s liquidity. The liquidity of a crypto asset is stronger when the bid-ask spread is smaller, and lower liquidity gives room for more slippage and potential for volatility.
To understand liquidity very well, there are some terms and concepts around it that must be understood as well, and they are as follow:
- Order Book
An order book is a ledger that shows all the buy and sells orders or instructions from traders in the market. The order book also shows the current situation in the market or what is called the order depth.
For the successful execution of a trade, bids and asks are matched as soon as their preset requirements are satisfied and fulfilled. In a market, there are two types of orders that a trader can set, and they are the market order and the limit order.
- Market Order: in this type of order, the instruction is to execute the order immediately at the best price available. This type of order is considered a priority in the market and is filled first by sellers and buyers whose orders are currently in the order book.
- 2. Limit Order: the instruction from a trader in this type of order is to buy or sell a particular amount of the assets at a price specified by the trader. If the order is a buy limit order, it can only be executed at the limit price or a lower price while a sell limit order would be executed at the limit price or a higher price. As long as the market price has not reached the limit price set by the traders, the trade will not be executed and it will wait unless the trader deletes the order or override the instructions.
- Order Depth
Order depth is the total number of limit orders in the leger called an order book. The order depth of an asset can be calculated by summing up the total volume of the limit orders placed already.
Order depth gives the real-time details of the total numbers of buyers and sellers whose orders have not been executed in the order book. It also shows the price at which they want their order to be executed. Also, there is the quantity column that shows the total number of units instructed in the order to process at the stipulated price. In order depth, there is always a “Total” column that shows the total number of contracts or orders accumulated already.
Consider the illustration, if the current Bid (buy) price for Bitcoin (BTC) is $31,985.00 and the best Ask (Sell) price is $31,985.50. For the price of BTC to move higher, buyers must fulfill the total number of orders and contracts available at $31,985.50.
Here is how this concept affects liquidity: the deeper the order book of an asset is on an exchange, the better the liquidity of the asset. This is because a deep market affords the market the ability to maintain prices when processing large transactions—also, the greater the order depth, the lower the chance of price manipulation.
- Importance of Liquidity in Crypto Trading
When the liquidity of an asset is low, the price of the asset can be unstable which can give more room for price manipulations and high slippage. Also, lower liquidity can imply longer waiting times, and it could affect traders adversely, especially in case of a market swing. One of the things that makes a good trader is the understanding of how liquidity affects their transactions, and they must develop the best strategies for picking the assets with better liquidity.
Understanding Slippage in Crypto Trading
Slippage is the difference between the actual price order was executed and the expected price of the trade. Oftentimes, there is not enough volume or interest to fulfill an order as the price set by the trader (expected price), especially for large orders. In this scenario, a part of the order is filled as the next price available.
Also, Slippage occurs when there is high volatility in the market. In those periods, the buy-ask spread between the time the market order was placed by the trader and when the exchange or marker maker executes the order. The correlation between slippage and liquidity is negative. In other words, the relationship between liquidity and slippage is inverse, meaning slippage is low when liquidity is high, and the slippage is high when liquidity is low.
- How Slippage Happens
In basic terms, Slippage happens when you initiate a market order, and the buy or sell order is matched by the exchange to the limit orders waiting in the order book. The order book will simply fill the order you created with the best price available. However, if the trading volume at your desired price is insufficient, the order book will look up the order chain for the next best price available. Eventually, the order might be executed at a price lower than what you desired initially.
Here is an illustration, if you are trying to acquire 100 units of a crypto asset whose price is currently at $100, but there is not enough liquidity in the market to execute your order, your execution price will be different. For your order to be executed, you will have to set the bid price of your order to a price above $100. Eventually, this will make the average buying price more than the $100 intended for the transaction.
Slippage is a common concept in decentralized exchange (DEX), especially those without dedicated market makers. Also, it is likely to happen when there is low liquidity or high volatility in the markets.
- Positive Slippage
Slippage is not always bad in crypto trading. There are times you have positive slippage when you place a buy order, and the price of the asset is reduced before your order was filled. This means that the price at which your order was executed is lower than the price inputted in the buy market order. Also, you can have a positive slippage when you file a sell market order, and the price increase eventually. If the execution price for your order is better than the expected price, you will get a positive slippage which will result in a more favorable trade for you.
- Negative Slippage
Here is where slippage becomes a concern for crypto traders. When the execution price of a sell market order is lower than the expected price of the order when filed or when the execution price of a buy order is higher than the price instructed in the order, the trader faces negative slippage. Remember, the goal of every trade is to buy at the lowest price possible and sell at the highest price possible.
- How to Calculate Slippage
The slippage of trade is expressed in two ways; in the dollar amount and as a percentage. However, before you can calculate the percentage, you must establish the dollar amount. The dollar amount can be calculated by getting the difference between the final price the order was executed and the expected price for the order. As established earlier, slippage is not always bad. It hits only when it is negative.
Slippage, on most platforms, is expressed in percentages, and it is important to understand how to go about it together with the calculation of the dollar amount. To calculate slippage in percentage, divide the dollar amount of the slippage with the difference between the worst execution price possible and the price you are expecting to get. To make a percentage finally, you will be required to multiply it by 100. In this case, the worst price possible is the limit price entered when filing a limit order. in this case, it is assumed that the type of order is limit order instead of market order.
Here is the formula: % Slippage = Slippage in $/ (LP – EP) x 100. Where LP is limit price or the worst price possible and EP is the expected price.
For instance, if you want to purchase a bitcoin at $47,000 and you are not willing to pay more than $47,500. Say you filed a limit order at $47,000, which is the current price, and the limit price instructed is $47,500. If the order was not executed until the price of BTC reaches $47,250, then your slippage is negative $250.
To express the slippage as a percentage, you will divide the slippage ($250 in this case) by $500 (which is the difference between the price you expected and the worst price possible). This will give 0.5 and will become 50% when converted to a percentage.
- How to Combat and Minimize Slippage in Crypto Trading
The swift and rapid change in prices, depending on liquidity and volatility is the main reason for slippage. And it is quite impossible to stage a fight against it. however, there are some tips and tricks that can be employed and traders must be aware before they start trading.
The most important way to minimize slippage is to make use of limit orders when trading instead of market orders. The reason is simple; market orders are executed at the next available price. And by implication, you can exact no control on the price your order(s) will be executed.
However, when you are using market orders, you can be sure that your orders will be executed, especially when you are using a more popular exchange or you are trading a popular crypto asset, because the order book is full, and there are orders in either direction (buy or sell) ready to be fulfilled.
So, a way to minimize slippage is to use limit orders. Limit orders allow you to set the highest possible price you are willing to buy an asset or the lowest price you are willing to sell. Here is the caveat, there is no guarantee that your order will be fulfilled and executed because the price might stay within come boundaries within the timeframe you set for the order.
Some crypto exchanges are programmed to warn you when you are bound to suffer a slippage percentage above a certain amount you set. An example is the Coinbase Display warnings which kick in at about 2% and higher.
Another way to combat and minimize your slippage attack in crypto trading is to split your orders. Instead of executing a large order at a time, you can execute it bit by bit. Also, you will be required to monitor the order book to ensure that the orders you are placing are not more than the trading volume available.
Slippage attack has been considered a serious problem in crypto trading because of the volatility of the market. with the rapid changing of the market prices, the chances of traders getting a price higher than what they wanted are getting higher. Also, low liquidity can kick in when buyers are not willing to trade at the price set by the sellers.
What is [Bid-Ask] Spread?
Spread is another important concept in crypto trading, and it must be well understood. In this section, we will look into how it works and how it can be calculated.
- What is Bid and Ask, and What is Spread?
The Bid price is the current price a trader is willing to pay to purchase an asset. At the moment you place a request to buy an asset in the order book, you are bidding for the asset, and in the same vein, the asking price is the current price sellers are willing to release their asset.
Spread, however, is the difference between the asking price (the lowest price a seller is willing to release an asset) and the bid price, which is the highest price buyers are willing to pay to acquire the same asset. In real-time markets, the spread is calculated from the difference between the sellers’ and buyers’ limit orders. The technical terms used in the order book are called Bids and Asks.
- Calculating the Bid-Ask Spread Percentage
The best way to express the bid-ask spread is in percentage. And here is the formula:
% Bid-Ask Spread = [(Ask Price – Bid Price)/Ask price] x 100
For example, if the bid price of an asset is $3.95 and the asking price is $4.05, the % Bid-Ask Spread will go like this:
[(4.05 – 3.95)/4.05] x 100 = 2.5% when rounded up to the nearest tenth.
Here is the implication of the figure: the smaller the spread, the more the asset is liquid. If you are dealing with an asset with a lower spread and you are executing a substantial market order, the chance of paying an unexpected price is lower. And it also means your slippage is minimal.
Conclusion
The objective of this guide is premised on the belief that crypto traders should be ready to deal with slippage in the market. They must learn how to calculate it, and must also understand how limit orders can be a solution to combating and minimizing slippage.
It is even more critical to understand these concepts, especially slippage when you are using decentralized exchanges. By the way, you must be aware that there is an underlying risk attached to crypto trading, and you must be ready to be responsible for all the financial decisions you take.