In trading, price movements are front and center to all investor activity. Rises and falls in prices are inherently part of the repertoire of the markets. Trading Bitcoin (BTC) and other cryptocurrencies is no different, especially with the increasing popularity and sophistication of crypto marketplaces.
One term you may come across in this field is “slippage.” Some have even labeled two aspects of trading – slippage and commissions – as a minus-sum game, not a zero-sum game. Professionals handle these effectively, but novice traders, people argue, aren’t aware of the ramifications posed by slippage, especially in cryptocurrency trading, where some order books lack the necessary depth and are therefore prone to slippage.
Let me take you through what slippage is, the ways of minimizing it, and how far some exchanges are going to eliminate it.
What Is Slippage in Cryptocurrency Trading?
Slippage refers to the difference between the expected and the actual price at the time a trade is executed. With slippage, the market participant gets a different execution price, in either direction, from the intended price. Although they can occur anytime, slippages are most prevalent during periods of heightened market volatility, marked by a surge in market orders.
In this definition of slippage, there are two fundamental elements: the expected price and the actual price. Slippage is concerned with the discrepancy between the two. The time between the ask/bid and the execution is where slippage comes in.
A trade order is an investor's instructions to an exchange to purchase or sell a digital asset. The execution point of an order is the completion of a buy or sell order of the given digital asset.
In the normal course of trading, various factors contribute to slippage in digital asset prices. Traders often enter or exit trades at a price either higher or lower than they desired. Slippage occurs when there is a change in the bid/ask spread.
This results in a market order getting executed at a price either more or less favorable than the intended price. One would ordinarily assume that slippage is only a negative phenomenon, but trade orders can also be executed at a higher price than the ask price.
Let’s look at an example of negative slippage.
Let’s say Bitcoin (BTC) is trading at $9,567/$9,569 on an exchange’s interface. Then, a market order of 100 BTC comes in with the intention of getting filled at $9,569. However, the microsecond transactions of computerized programs increase the bid/ask spread to $9,569/$9,571 before the order is filled. Let’s say the order gets executed at $9,571. That means a trader will incur a $2 loss per BTC purchased, for a total loss of $200, thanks to slippage.
Why Does Slippage Occur?
Slippage happens when traders use market orders. Traders sometimes use market orders to enter and exit positions in times of high volatility. Slippage is a result of market volatility and can happen on account of market-moving news that makes it impossible to execute orders at the price the trader makes the market order for.
For instance, if a large order is placed when there is insufficient buying interest in an asset to maintain the expected trade price, slippage can occur. High-volatility markets also exhibit this phenomenon.
Cryptocurrency traders will likely execute a trade where there is slippage at the next best asset price unless there is a limit order to stop the trade at a particular price.
What are some of the risks when slippage occurs? Most prominent is the risk of losses from a large order that has negative slippage. Alternatively, a series of negative slippages can have the same effect. The risks are obviously more apparent in highly volatile markets.
Crypto exchanges like Xena Exchange are now dynamic and vibrant marketplaces. Slippage is also a part of regular crypto trading because there is no life in a static market. Cryptocurrency is notorious for its fast price fluctuations. When there is an imbalance in trade volumes, meaning there are either significantly more sellers or buyers, the prices will reset to the next available price. For a relatively young market like crypto trading, the high volatility means that slippage is an ever-present factor.
How to Avoid Slippage in Trading
It is evident that slippage can set you back as a trader. Negative slippage, in particular, is an unfavorable outcome. In a large order, even marginal slippage can compound into something significant. Therefore, when investing in crypto, the issue of how to prevent slippage in trading is pertinent.
Crypto trading is not a skill you can master overnight. Features like slippage make learning different strategies all the more important. After all, there is nothing to lose from having more knowledge and trading expertise. Trading cryptocurrency pairs can be a rewarding experience if you get it right.
In managing slippage, it is important to acknowledge that coin markets exhibit volatility. Trading without slippage management measures is highly risky. In live crypto trading, there is always the risk of slippage. Sometimes, it is impossible to entirely avoid slippage between enter and exit positions. However, you can mitigate the effects of slippage through certain measures.
Let’s look at some of the ways to combat slippage in crypto trading.
- Use Limit Orders
Since slippage is the movement that occurs between entry and exit trading positions, the main way to manage risk is to use limit orders. Limit orders, instead of regular market orders, prevent traders from executing a trade at a worse price than intended.
A limit order is a request to buy or sell an asset at a specified (or better) price. If the other side of the order book doesn't contain orders with a suitable price, the limit order will remain in the book until it is hit by another market participant or canceled without being filled. As such, a limit order will only execute at a specified or “better” price.
With limit orders, you don’t enter into a position if the price goes beyond the limit. Limit orders can prevent you from incurring slippage. Instead, you incur the risk of possibly missing out on markets that require market orders for fast-moving market conditions.
Limit orders can cover exiting positions as well. A limit sell order allows you to specify a certain price to make a precise exit from the market. For the crypto market, you can set a specific price for your trade to get filled at in order to match orders with your position at the price you want.
A limit order is particularly useful when trading low-cap and high-volatility coins. However, they must be methodical and tactical to serve their purpose. For instance, traders can use a limit buy order for a coin with momentum at the precise moment of a “pullback.” A pullback is a dip in prices for a coin that is generally part of a rally.
A stop-loss order is yet another market order type. A market order is a request to buy or sell an asset at the current market price. Note that if the quantity of a market order is too big, it may not be executed at the best price, as it will be matched against several limit orders in the order book. The resulting execution price is the weighted (by execution volume) average of the limit orders that have been executed.
Stop-loss orders execute when certain conditions materialize. They are executed as market orders when they are activated and are therefore IOC (immediate or cancel) by default but can also be set to FOK (Fill or Kill) on Xena Exchange. Experienced traders can use a combination of stop-loss and limit orders with a certain percentage range to ensure guaranteed stops.
- Study Market Events and News Cycles
The primary driver of slippage is volatility. Volatility comes about because of market-moving news events and developments. Therefore, the best way to avoid slippage is to monitor what actually moves the markets. Traders should actively follow the economic calendar for news that affects assets they have an interest in. News can give investors an indication regarding the direction in which the asset may move.
In crypto markets, developments in regulations or coin communities such as a hard fork can swing prices momentarily. Monitoring information regarding such developments is crucial when trying to avoid negative slippage.
When engaging in cryptocurrency day trading, it is wise to avoid placing market orders when the market is anticipating an important market-moving event. The big moves that occur can be attractive, but it is difficult to avoid slippage. Unless you are certain that the slippage will not affect you negatively, it is better to sit out.
In general, high-volatility periods are not a great time to enter into positions. The risk that comes along is simply hard to manage. A period like the announcement of a major partnership or a regulatory or political shift can come with significant slippage.
Slippage on Exchanges
Slippage is a core component of trading markets. The fact that it is such an important consideration has given rise to quantitative broker slippage. Brokers compete based on who can offer the best slippage.
In the cryptocurrency markets, slippage is a big deal. When day-trading crypto pairs, profit margins are all about the small movements, and managing slippage is consequential to your fortunes. Exchanges that offer low slippage rely on fast technology with instantaneous execution. Low-slippage brokers typically state this advantage on their website or in their advertisements.
Alternatively, you can limit slippage by using exchanges or brokers that offer instant execution rather than market execution. Working with brokers with no slippage requires setting a specific price. This can be a useful service in a fast-moving market, but it can fail if the price becomes unavailable.
Examples of Slippage Trade
Let’s look at the respective types:
Slippage in stock trading
In stock trading, slippage comes about as a result of a change in spreads. Spreads in trading simply refer to the difference between the ask and bid prices of an asset. When trading stocks, liquidity is a great parameter to examine. Liquid stocks typically have tight spreads and low slippage, allowing investors to enter and exit at a good price. Therefore, trade largel-cap stock to avoid slippage. Small-cap stocks come with greater volatility than higher-cap stocks, meaning that slippage is more prevalent. Higher cap stocks tend to have a healthier balance of supply vs. demand, which reduces slippage.
Slippage in Forex trading
Forex slippage takes place when a market order executes or the stop-loss closes the position at a different rate from when the trader set the order. Slippage is more likely in a forex market when volatility is high because of news events that turn the markets or when a currency pair trades outside peak market hours. In both scenarios, reputable forex dealers execute the trade at the next best price. More liquid currency pairs are less prone to slippage, although this changes with market volatility.
- Managing slippage is a skill necessary to manage risk when executing trades because crypto markets are inherently volatile.
- Slippage can strongly degrade your expected trading result. Always keep this factor in mind when testing your strategies.
- Slippage occurs only when using market orders. Use limit orders to prevent slippage.