Detailed explanation of bid-ask and slippage spreads
The bid-ask spread is the difference between the lowest asking price and the highest asking price of an asset. Assets like Bitcoin typically have tighter spreads than assets that are less liquid and traded.
A slippage occurs when the average price at which a trade settles deviates from the initial demand. Slippage spreads generally occur when executing market orders. The final order price may change if the liquidity is not sufficient to support the order execution or the market fluctuates. To deal with sliding spreads on illiquid assets, try dividing the order into several smaller orders.
When buying and selling assets on a cryptocurrency exchange, market prices are directly affected by supply and demand. In addition to price, important factors such as volume, market liquidity and order type should also be considered. Due to market conditions and the selected order type, the transaction may not be completed at the ideal price.
Buyers and sellers come and go, and there will be a price difference (that is, the bid-ask spread) during the negotiation process. Depending on the volume and volatility of the asset, there may also be slippage spreads (more on this later). In order to avoid surprises, it is helpful to know the basics about the order book of a trading platform.
What is the bid-ask spread?
The bid-ask spread is the difference between the highest bid price and the lowest ask price in the order book. In traditional markets, spreads are usually triggered by market makers, brokers or liquidity providers. In the cryptocurrency market, the spread is the result of differences in limit orders between buyers and sellers.
A buyer who wishes to buy at the market price will accept the seller's lowest asking price. Conversely, if the seller wishes to sell immediately, the buyer's highest offer is also accepted. Assets with excellent liquidity (such as foreign exchange) have relatively low bid-ask spreads, and buyers and sellers can execute orders without causing significant price changes in the asset. The reason behind this is that there is a large number of orders in the order book. When these large orders are closed, the bid-ask spread increases, causing large price swings.
Market makers and bid-ask spreads
"Liquidity" is an important concept in financial markets. If you try to trade in a illiquid market, it will likely take hours or even days for your order to be matched with other traders.
Activating market liquidity is very important, but some markets cannot get enough liquidity from retail investors alone. For example: in traditional markets, brokers and market makers can earn arbitrage income by providing liquidity.
Market makers only need to buy and sell the same asset to play the bid-ask spread. Selling at a high price and buying at a low price, in this cycle, market makers can use the price difference to arbitrage. Even small spreads can generate substantial gains as long as large-scale trades are carried out 24/7. High-demand assets have smaller spreads because market makers compete with each other to narrow the spread.
For example: a market maker can simultaneously buy Binance Coin at a unit price of $350 and sell Binance Coin at $351, creating a $1 spread. Anyone in the market looking to trade instantly is bound to match their positions. Through the above-mentioned buying and selling behavior, market makers can pocket the price difference as pure arbitrage income.
Depth charts and bid-ask spreads
Let's take a look at some real-life cryptocurrency examples and explore the relationship between volume, liquidity, and bid-ask spreads. Open the Binance Exchange UI and switch to the [Depth] chart view to easily view the bid-ask spread.
Under the [Depth] option, the order book for the asset is displayed graphically. Green shows the buy quantity and offer price, and red shows the sell quantity and ask price. The difference between the red and green areas is the bid-ask spread, which can be calculated by subtracting the green offer price from the red ask price.
As mentioned above, there is an implicit correlation between liquidity and lower bid-ask spreads. Trading volume is a commonly used liquidity indicator. The larger the trading volume, the smaller the ratio of the bid-ask spread to the asset price. Larger cryptocurrencies, stocks and other assets face accumulating competition as traders seek to profit from bid-ask spreads.
Bid-ask spread
In order to compare bid-ask spreads for different cryptocurrencies or assets, it is more intuitive to evaluate as a ratio. The calculation is very simple:
(Ask Price - Quote) / Ask Price x 100 = bid-ask spread
Let’s take the BIFI token as an example: BIFI has an asking price of $907 and an offer of $901. That is, the bid-ask spread is $6. Dividing $6 by $907 and multiplying by 100 yields a final bid-ask spread of about 0.66%.
Now, let's say the Bitcoin bid-ask spread is $3. Although this value is only half of BIFI, if converted into a ratio, the bid-ask spread of Bitcoin is only 0.0083%. The significantly lower volume in BIFI just confirms our theory that bid-ask spreads are generally higher for illiquid assets.
We can also draw some conclusions from Bitcoin’s low spreads. Assets with low bid-ask spreads are likely to correspond to high liquidity. If you want a large market order at the moment, the risk of the order price not meeting expectations is usually less.
What is a sliding spread?
Slip spreads are often the product of high market volatility or illiquidity. Slip spreads are created when a trade fails to settle at the expected or desired price.
Example: Suppose you want to place a high market buy order at a unit price of $100, but the market is not liquid enough to be filled at this price. In desperation, you can only accept later orders (unit price higher than 100 US dollars) until the final transaction. As a result, your average buy price is over $100, creating what is known as a "slippage."
In other words, when a user creates a market order, the trading platform automatically matches the buying and selling action to the limit order in the order book. The order book matches the best price for the user, and if the volume corresponding to the target price is insufficient, the order will continue to match the higher price in the order chain. This will cause the user's order to fail to be traded in the market at the expected price.
In the cryptocurrency space, slippage spreads are often seen in automated market makers and decentralized exchanges. For volatile or illiquid altcoins, slippage spreads can exceed 10% of the desired price.
Positive slippage
Sliding spreads do not mean that you will end up closing at a worse price than expected. Positive slippage spreads occur when the price falls when you place a buy order, or rises when you place a sell order. While positive slippage spreads are uncommon, they do occur occasionally in volatile markets.
Slip Spread Tolerance
Some trading platforms allow manual setting of slippage tolerance levels to limit potential slippage. Automated market makers generally have this option, such as Binance Smart Chain's PancakeSwap and Ethereum's Uniswap.
The amount setting of the sliding spread will jointly affect the order settlement time. If the sliding spread is set low, the order may take a long time to fill, or it may not fill at all. If the setting is too high, the order will remain in the pending state, and other traders or robots will grab the trading opportunity.
In this case, other traders only need to increase the gas fee to be the first to close the transaction and buy the asset first. After that, the front trader refers to the sliding spread tolerance, establishes another trade at the highest expected price of the tolerance setter, and sells the asset back to the setter himself.
Try to avoid negative sliding spreads
Slippage spreads are unavoidable, but the impact can still be minimized with some trading strategies.
Attempt to "break down" large and large orders into zero. Keep a close eye on the order book, then spread out orders to ensure that the total order book does not exceed market volume.
If you use a decentralized trading platform, don’t forget to consider the transaction fee factor. In order to prevent sliding spreads, some networks will charge high fees based on blockchain traffic, causing all revenue to go to waste.
If dealing with illiquid assets (such as small liquidity pools), trading activity will have a significant impact on asset prices. The sliding spread of a single transaction may be small, but the accumulation of a large number of small spreads will also affect the price of subsequent block transactions.
Use limit orders. A limit order allows a trade to be filled at the desired price or better. Although not as fast as a market order, any negative slippage can be avoided.
Summarize
When trading cryptocurrencies, don’t forget that bid-ask or slippage spreads can affect the final traded price. The two cannot be completely avoided, but they can provide valuable reference for transaction decisions. For small transactions, the impact of the two is minimal. However, in the case of large-scale orders, the average unit price may be higher than expected.
Last updated