Slippage plays an important role in trading cryptocurrencies for retail investors as it determines the difference between the amount that you expected to pay in a transaction and the amount the trade was executed at. Below we're uncovering what slippage in crypto is, explaining how it can contribute to risk, and providing some practical examples on how to avoid it.
What is slippage in trading?
Slippage is when an trader opens a trade but between creating the trade and the trade executing, the price changes due to price movements in the greater market. This can often be a costly problem in the financial sector and particularly when trading digital currencies on crypto exchanges.
How does slippage occur?
The two main causes of slippage are volatility and liquidity, outlined in more information below.
Volatility is when the price changes rapidly, as is common in cryptocurrency markets, and as a result the price changes between the time of creating the buy or sell order and the time of execution.
Liquidity concerns on the other hand are when the coin you are trading is not traded very often and the range between the lowest ask and the highest bid is wide. This can cause sudden and dramatic price changes, resulting in slippage. Fewer people trading an asset results in fewer asking prices, resulting in less favourable prices.
This is common among altcoins with low volume and liquidity. While slippage can occur in forex and stock markets too, it is much more prevalent in crypto markets, particularly on decentralised exchanges (DEXs).
There are two types of slippages:
Positive Slippage
Positive slippage is when a trader creates a buy order and the executed price is lower than the price initially expected. This will result in the trader getting a better rate. The same is true for a sell order that experiences a higher price point at trade execution, resulting in more favourable value for the trader. Positive slippage banks profits.
Negative Slippage
Negative slippage is when the trader loses out on the trade, with the price of the buy order higher than expected at the time of execution. The opposite is true for sell orders, meaning that the execution price is lower at the time of execution, similarly resulting in losses for the trader.
Can slippage be avoided? How to avoid slippage
While one can't eradicate slippage entirely, there are several measures one can take to better manage slippage, as regularly falling victim to negative slippages can result in losing a lot of money.
- Create limit orders
Instead of creating market orders, traders can instead create limit orders as these types of trades don't settle for unfavourable prices. Market orders are designed to execute a trade service as quickly as possible at the current available price.
- Set a slippage percentage
Traders can create a slippage percentage that eliminates trades happening outside of the predetermined range. This can range from 0.1% to 5%, however, if the slippage percentage is too low this could lead to the trade not being executed and the trader missing out on large drops/jumps.
- Understand the coin's volatility
When in doubt, get educated. Learn about the coin's volatility as well as the volatility on the trading platform you are using. Understanding more about previous patterns can assist in making more informed decisions on when to open and close a position, and avoiding negative slippages.
How to calculate slippage
Slippage can be calculated in two ways, either in dollar amount or percentage. Although to work out the percentage, you will first need the dollar amount. This is calculated by subtracting the price you expected to pay from the price you actually paid. This amount will indicate if you incurred a positive or negative slippage.
Most exchanges express this amount in percentages. This is calculated by dividing the dollar amount of slippage by the difference between the price you expected to get and the limit price. Then multiply that by 100.
For example, say you are looking to buy Bitcoin for $50,000, but are not willing to pay more than $50,500. When the price is at $50,000 you will create a limit order of $50,500, however, the order executes when the price reaches $50,250. This will result in a $250 slippage.
To calculate the percentage, divide $250 by $500 (the difference between the price you expected to pay and the limit order). 0.5 multiplied by 100 equals 50%.
In this case, your slippage was $250 or 50%.
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