Before you start actively trading cryptocurrencies, it is crucial to understand some basic nuances of trading.
One of the key concepts are spread and slippage. Incorrect understanding of these terms can turn into serious financial losses for the trader. In this article we will discuss in detail the essence of spread and slippage, what they consist of, how they affect the profitability of trading and how to minimize their negative impact.
Spread on the market: definition and essence
Spread is the difference between the price of buying and selling an asset at a particular moment of time. In other words, it is the range of rate fluctuations within which a trader has to act when opening or closing a position.
In more detail it looks as follows: the order book of the exchange constantly records orders both for buying an asset at a certain price and for selling it. The set of all current limit orders to buy at the highest price forms the total demand and determines the best bid price.
Similarly, all current sell orders at the lowest price form the total supply and the best ask price. The difference between the best bid and ask prices at each moment is the current spread.
For example, the following limit orders appear in the order book for the BTC/USDT pair:
- Buy 1 BTC at $48,600
- Buy 1 BTC at $48,590
- Sell 1 BTC at $48,650
- Sell 1 BTC at $48,680
So, the best bid price is now $48,590 and the best ask price is $48,650. The spread is equal to $48,650 - $48,590 = $60.
This mechanism of spread formation is typical for most crypto exchanges.
How market makers influence the spread: explanation of mechanisms
Market makers are professional market participants who ensure liquidity of assets by regulating supply and demand.
The main task of market makers is to provide bilateral quotes and guaranteed execution of orders on them on a regular basis. That is, at any moment they should be ready both to buy an asset at their own prices and to sell it from their own portfolio. This ensures market stability and reduces time intervals between deals.
How exactly do market-makers influence the spread? They independently determine its size by setting different prices for buying and selling assets. This difference is the very spread they earn on.
Let’s look at an example. If the average price of BTC at the moment is $51000, a market maker can set the following quotes:
- Buy BTC: $50900
- Sell BTC: $51100
That is, the spread in this case will be $51100 - $50900 = $200. The difference of $200 is the spread that the market maker receives as income. The more volatile and liquid the asset is, the smaller the spread is usually set by market makers to stimulate trading activity.
Also, market makers can quickly adjust their orders, reacting to changes in market conditions. For example, in case of sharp volatility spikes the spread can be temporarily increased to reduce risks.
Thus, the cost of transactions for other traders directly depends on the actions of market makers.
How to calculate the spread percentage?
Calculating the spread percentage is a simple operation to comprehensively evaluate the current liquidity and trading costs of working with a particular crypto asset on the market.
The formula for calculating the spread percentage is as follows:
Spread percentage = (ask - bid) / ask * 100%, where:
Ask is the best selling price of the given asset, and bid is the best buying price.
The lower the value of this percentage, the narrower the spread and higher the liquidity.
Let’s calculate the spread percentage using a concrete example:
- In real time, we look at the current buy and sell prices of the currency pair we need. For example, for BTC/USDT these values are: ask (selling price) — $52,500, and bid (buying price) — $52,300.
- We find the difference between the best bid and ask prices: $52,500 - $52,300 = $200. This difference is the current spread in absolute terms.
- Then we divide the obtained value of the spread by the best selling price: 200 / 52 500 = 0.0038
- Multiply the result by 100% to get the percentage: 0.0038 * 100 = 0.38%
Total, the current percentage of the spread on the BTC/USDT pair is 0.38%.
What does slippage mean?
Slippage is a widespread phenomenon when trading volatile and low-liquid assets, which includes most cryptocurrencies.
Slippage refers to the situation when the actual order execution price deviates from the one that the trader originally expected at the time of order submission. Most often, this applies to market orders that are executed immediately at the current price on the trading floor.
This is due to the high volatility and lack of liquidity of crypto assets. When a trader places, for example, a market order to buy Bitcoin at the current price of $51000, the price can shift to the level of $51200 in a second.
And although the exchange was showing a price of $51000 at the time the order was submitted, the trade will actually be closed at the higher value. This happens because the volume of orders to buy at the price of $51000 was insufficient, and the system «slipped» to the next orders in the order book.
As a result, the real price turns out to be worse than expected. This difference between the planned and actual price of the deal is called slippage. The higher the volatility and lower the liquidity of the asset, the more serious are the risks of slippage.
Similarly, when selling, the value of the asset may increase — if the price manages to increase by at least a fraction of a percent after the order is submitted, it will be considered a positive slippage.
Although such phenomena are the exception rather than the rule, experienced crypto traders skillfully take advantage of such rare opportunities for additional profit.
How to reduce slippage risks?
Minimizing negative slippage when trading cryptocurrencies is one of the most important tasks a trader faces. Let’s analyze the main ways to reduce these risks:
- Splitting large orders into smaller parts allows you to gradually accumulate the required volume of assets at the optimal price without creating sudden bursts of supply/demand. It is optimal to split the total volume into parts not exceeding 5-7% of the average daily trading volumes of the selected pair.
- Choosing a favorable time for opening and closing positions. It is necessary to study and take into account the periods of increased volatility during the day, release of important news, publication of macroeconomic data.
- The use of limit orders with fixation of the maximum acceptable price instead of market orders allows to completely exclude the risks of negative slippage.
- Careful selection of the most reliable and liquid trading pairs and exchanges. On popular pairs with high trading volume (BTC/USDT, ETH/USDT) slippage is usually minimal.
- The use of stop-losses and take-profits for automatic closing of positions in a given price range also allows you to narrow possible losses from sharp price jumps.
A deep understanding of market principles, studying statistics and combining different approaches is the key to minimizing all risks in crypto trading, including price slippage.
Conclusion
Spread and slippage are the most important characteristics of liquidity and volatility of the crypto market, directly affecting the profitability of traders’ operations.
Spread shows the current level of liquidity and transaction costs. The narrower the spread, the more favorable conditions for opening transactions. Slippage reflects the gap between the expected and real price of order execution. It occurs on highly volatile and low-liquid markets.
To minimize the risks from volatility, you should use limit orders, as well as stop-losses and take-profits. This will partially insure against sharp price changes. In general, successful trading in crypto assets requires a comprehensive approach. It is necessary to take into account both technical analysis and understanding of the economic mechanisms of the market.
