Slippage occurs when the average price of a trade is different than what was initially expected. Slippage usually happens when using market orders, often because there’s not enough liquidity to fill your order or the market is volatile, causing the final order price to change.
So, instead of getting the exact price you want, slippage may cause the trade to cost more or less. Traders try to reduce slippage by breaking big trades into smaller parts or using limit orders that let them set a specific price for buying or selling.
Bid-Ask Spread
To fully understand slippage, it’s essential to understand the bid-ask spread. This spread represents the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask). The bid-ask spread is influenced by factors such as market liquidity and trading volume. More liquid assets, like Bitcoin, typically have a smaller spread due to a higher volume of orders in the market.
Slippage Example
Consider a scenario where a trader places a large market order at $100, but the market lacks the necessary liquidity. The order may get filled at prices above $100, resulting in an average purchase price higher than anticipated. This discrepancy between the expected and actual prices is what we refer to as slippage.
Positive Slippage and Slippage Tolerance
While slippage often implies a less favorable outcome for traders, positive slippage can occur if prices move in favor of the trader during order execution. Some exchanges allow users to set a slippage tolerance level, influencing how much deviation from the expected price is acceptable. This option is common on decentralized exchanges and DeFi platforms.
Balancing slippage tolerance is crucial, as setting it too low may delay order execution or cause the transaction to fail. Setting the slippage tolerance too high risks exposure to undesired price levels.
Minimizing Negative Slippage
Traders can employ strategies to minimize negative slippage:
1. Split large orders: Dividing big orders into smaller ones can reduce the impacts of slippage.
2. Set a slippage tolerance level: Most decentralized exchanges and DeFi platforms allow you to set your slippage tolerance level (e.g., 0.5%, 0.1%, custom, etc.).
3. Be mindful of liquidity: Low-liquidity markets can impact asset prices and are more likely to cause slippage.
4. Use limit orders: Although slower than market orders, limit orders ensure only specific prices or better are used, mitigating the negative effects of slippage.
