Slippage

Slippage happens when the actual price of a trade differs from the expected price. This typically occurs with market orders, often due to insufficient liquidity to fill the order or market volatility, resulting in a change in the final order price.

Instead of achieving the desired price, slippage may cause the trade to cost more or less. To minimize slippage, traders split large trades into smaller parts or use limit orders to set specific buying or selling prices.

Understanding the Bid-Ask Spread

To comprehend slippage, it's crucial to grasp the bid-ask spread, representing the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask). Factors such as market liquidity and trading volume influence the bid-ask spread, with more liquid assets like Bitcoin typically having a smaller spread due to higher order volumes.

Example of Slippage

Imagine a scenario in which a trader places a large market order at $100, but the market lacks sufficient liquidity. The order may be filled at prices above $100, leading to an average purchase price higher than expected. This discrepancy between expected and actual prices is what we refer to as slippage.

Positive Slippage and Slippage Tolerance

While slippage often implies an unfavorable outcome for traders, positive slippage can occur if prices move in favor of the trader during order execution. Some exchanges permit users to set a slippage tolerance level, affecting the acceptable deviation from the expected price. This feature is common on decentralized exchanges and DeFi platforms.

Balancing slippage tolerance is critical, as setting it too low may delay order execution or cause transaction failures. Conversely, setting the slippage tolerance too high risks exposure to undesirable price levels.

Minimizing Negative Slippage

Traders can employ strategies to minimize negative slippage:

1. Split large orders: Dividing significant orders into smaller ones can reduce slippage impacts.

2. Set a slippage tolerance level: Most decentralized exchanges and DeFi platforms allow users to set their slippage tolerance level.

3. Consider liquidity: Low-liquidity markets can impact asset prices and increase the likelihood of slippage.

4. Use limit orders: Although slower than market orders, limit orders ensure specific prices or better, reducing the negative effects of slippage.

Conclusion

In conclusion, it is important for traders to comprehend the concepts of bid-ask spread and slippage to make more informed decisions and to mitigate potential risks, especially in decentralized finance and decentralized exchanges.