Slippage is a term that is used to refer to the difference between the expected price and the actual price of a trade. Slippage typically occurs during periods of high volatility when executing market orders. A lack of liquidity in a market or a highly volatile market can contribute to the likelihood of slippage occurring. This article will provide a breakdown of how slippage works, the difference between positive and negative slippage, and strategies for how to minimise the impact of slippage.
Slippage is the difference between the expected price of a trade and the price at which a trade is executed. Slippage can occur in any market condition but occurs more often when large orders are executed in markets with insufficient volume, during periods of high volatility, or when a trader uses market orders.
Slippage can be defined as either negative or positive. Negative slippage refers to price differences that occur when an order is executed at a worse price than the trade intended (i.e higher than expected). On the other hand, positive slippage refers to a price difference that occurs when the executed price of an order is favourable to a trader (i.e lower than expected).
How does slippage work?
When you trade digital assets on a cryptocurrency exchange, there are a number of factors that contribute to price changes during trading. While market pressure to either buy or sell an asset drives price movements, other factors such as market liquidity, trading volume, and market volatility must also be taken into consideration.
The type of order a trader uses can also have an impact on the price of an asset during a trade. Market conditions and order types can cause scenarios in which a trader may not get the actual execution price they want for the trade.
In order to understand slippage, it’s important to first understand the bid-ask spread. Cryptocurrency markets are composed of two parties — buyers and sellers. These two parties create a difference between them, referred to as a spread.
How does the bid-ask spread affect slippage?
Within cryptocurrency markets, the spread is generally defined by limit orders created by traders on either side of the spread — orders seeking to sell or buy an asset at a specific price, rather than the market price.
A trader that makes a market order when trading a digital asset will need to accept the lowest ask price from another trader within the same market in order to instantly purchase the asset. Conversely, a trader seeking to sell an asset as fast as possible will need to accept the highest bid price from another trader.
Highly liquid markets generally have a high volume of orders within any given order book, creating a narrow bid-ask spread in which traders are able to create and execute orders with minimal price movement.
Markets with low liquidity and fewer orders within the order book, however, are likely to create scenarios in which slippage occurs.
If a market lacks sufficient liquidity to completely fill an order at the best possible price, the order will be filled at the next best possible price, increasing the total price of the trade.
An example of slippage
Steve wants to create a significant Ether (ETH) market buy order at a price of $1,000. The market, however, may not have sufficient liquidity to instantly fill Steve’s order at that price.
The order book will provide Steve with as much ETH as is available at a price of $1000 in order to fill the order. The rest of the order will subsequently be filled at prices above $1000 until the order is completely filled.
This mechanism can cause the overall price of the order to increase as the order book seeks to fill the order at the best possible price. Within the above example, there isn’t sufficient liquidity available at the desired price the trader wants to trade at, so the order book matches the closest possible price and fills the order.
Cryptocurrency prices can change very quickly when compared to traditional forex trading. This means that slippage is not always negative — it’s possible that a market order submitted by a trader in a low liquidity market may result in a better price change.
For example, Steve may create another large buy order for Ethereum at a price of $1000. Should the market lack the required liquidity to fill the order immediately, the order book will seek the next closest available price to fill the rest. If the price of the asset decreases during this time frame, the overall price of the trade will decrease as the order book fills the market order at a lower price (under $1000), causing positive slippage.
How to minimise negative slippage
Slippage is an inevitable part of trading digital assets on cryptocurrency exchanges when using market orders and cannot be avoided. There are, however, a number of strategies you can use to minimise slippage risk.
Use limit orders
There are many different order types you can use to minimise the impact of slippage. A limit order, for example, ensure that an order will not execute unless an asset is available to buy or sell at sufficient volume, at a requested price. While limit orders are not executed as quickly as market orders, they provide traders with confidence that the price of their order will not change.
Break down large orders
Breaking down large orders into smaller orders can help minimise the impact of slippage. Observing the available liquidity in a market allows a trader to create orders that do not exceed the available liquidity in any given market, reducing the likelihood that slippage will occur.
Make fewer transactions for low liquidity markets
Digital asset markets with low liquidity, such as small liquidity pools, are heavily susceptible to price action based on trading activity. Orders executed within low liquidity markets can greatly alter the price of an asset.
Significant price changes in low liquidity markets can be observed when “whales” — crypto investors that hold a large amount of crypto — “dump” assets by flooding smaller, volatile markets with a large number of coins, thereby causing significant price drops. Inversely, large buy orders within low liquidity markets can cause rapid increases in low liquidity asset prices.
A single transaction within a low liquidity market may not cause significant slippage, but many consecutive transactions can have a cumulative impact on prices, increasing the likelihood of slippage.
Minimise slippage with OTC
Large volume trades on regular exchanges can suffer heavily from slippage. A way to minimise slippage is through an Over the Counter (OTC) desk, which privately deals trades off the public exchange.
OTC is a service Swyftx provides for high-volume traders. Our OTC team have decades of experience to ensure trades are executed to the highest standard. Trading via OTC will grant access to high liquidity volume and tighter spreads. Our team also provides OTC traders with deep market insights, portfolio management and more. Visit our crypto OTC page to book a consult and learn more.
It’s important to remember that when you trade cryptocurrency you are trading assets with counterparties in a dynamic, shifting market. Cryptocurrency exchange order books execute orders as instructed.
Market orders can be considered an instruction to buy or sell an asset at the best price possible — should the market lack sufficient liquidity to fill an order at the best possible price, slippage that increases the total price of the trade may occur.
It’s not always possible to avoid slippage, but it is possible to reduce slippage by carefully observing liquidity in low liquidity markets or creating different order types.