Understanding Bid-Ask Spread and Trading Slippage: The Invisible Killer of Transaction Cost

Key Points

• The Bid-Ask spread is the natural price difference between buying and selling prices in the market, reflecting the supply and demand relationship and liquidity conditions.
• Slippage occurs when the actual execution price does not match the expected price, mainly caused by market volatility or insufficient liquidity.
• A narrower spread and lower slippage typically indicate a healthier market with greater liquidity.
• Understanding these two concepts is crucial for assessing the true cost of transactions.

Introduction: Why Pay Attention to Bid and Ask Prices

In cryptocurrency trading, the market price you see is just a surface phenomenon. What truly determines whether you can execute a transaction at your ideal price is the ongoing game between buyers and sellers in the order book.

When you decide to trade, in addition to paying attention to the basic price, you should also consider the trading volume, market liquidity, and the type of order you choose. Under different market conditions, even if you place the same order amount, the final execution price may vary significantly.

This involves two important concepts: the difference between the purchase price (Ask) and the selling price (Bid), as well as the accompanying slippage risk. Many traders tend to overlook these hidden costs, only to find that their profits have been eroded completely.

The Nature of Bid-Ask Spread

What is the Bid-Ask Spread? In simple terms, it is the difference between the highest buying Bid price and the lowest selling Ask price in the order book.

In traditional financial markets, liquidity providers (market makers) profit by creating spreads. However, in the cryptocurrency market, this spread is entirely determined by the limit orders of the market participants—buyers set the highest price they are willing to pay, while sellers set the lowest price they are willing to accept.

If you want to buy an asset immediately, you must accept the lowest Ask price proposed by the seller. If you want to sell immediately, you will receive the highest Bid price that the buyer is willing to offer.

The Relationship Between Liquidity and Spreads

Highly liquid assets (such as mainstream trading pairs) typically have narrower Bid-Ask spreads. This is because a large number of buy and sell orders are accumulated in the order book, allowing buyers and sellers to complete transactions quickly at close prices without significantly impacting market prices.

In contrast, assets with low liquidity tend to have wider spreads. A sparse order book means that any large transactions could drive prices up or down, thereby increasing the risks faced by traders.

Market Makers and the Profit Mechanism of Spreads

The Importance of Liquidity to the Market

In any financial market, sufficient liquidity is a prerequisite for smooth trading. If a market lacks liquidity, your orders may take a long time to be executed, or there may be no one to quote a price.

In certain situations, the market requires professional liquidity providers (market makers) to maintain trading activity. Market makers provide continuous trading opportunities by simultaneously quoting bid and ask prices.

How Market Makers Profit from Spreads

Imagine a scenario like this: a market maker simultaneously places two orders - buying a certain asset at a Bid price of $950 and selling the same quantity of the asset at an Ask price of $951. This $1 difference is their profit.

By continuously repeating this process—buying at lower Bid prices and selling at higher Ask prices—market makers can accumulate substantial profits. Even if the profit from a single transaction is thin, the cumulative effect becomes very significant when the daily trading volume is large enough.

High-demand assets attract more market maker competition, and in order to seize trading flow, they gradually narrow the bid-ask spread. This competitive mechanism ultimately keeps the bid-ask spread of mainstream assets at relatively low levels.

Practical Operation: How to Observe and Calculate Price Differences

On most trading platforms, observing the Bid-Ask spread is quite intuitive. Many trading interfaces offer a Market Depth feature that displays the order book in chart form.

In the depth map:

• The green area represents the quotes and corresponding quantities of the buyer (Bid)
• The red area represents the seller's (Ask) quotes and corresponding quantities.
• The gap between the two areas is the Bid-Ask spread.

To calculate the percentage of the price difference, use the following formula:

(Ask Price - Bid Price) / Ask Price × 100 = Spread Percentage

Example Comparison

Assuming the Ask price of a certain mainstream asset is $10,000 and the Bid price is $9,999, the spread is $1. Using the formula: (10000 - 9999) / 10000 × 100 = 0.01%

Now let's compare a low liquidity altcoin, where the Ask price is $10, the Bid price is $9.5, and the spread is $0.5. Calculation result: (10 - 9.5) / 10 × 100 = 5%

Although the absolute spread (0.5 USD) appears smaller than that of mainstream assets (1 USD), the relative spread is much larger. This clearly indicates that the same absolute spread has a completely different impact on different assets. The trading cost risks of low liquidity assets are greater.

What is slippage in trading

Definition and Causes of Slippage

Slippage refers to the deviation between your final transaction price and the expected price. It often occurs in markets with high volatility or low liquidity.

For example: You plan to place a large buy order at a price of $100. However, when your order enters the market, the number of sell orders at the $100 price level is insufficient to meet your entire demand. The system will automatically match with higher-priced orders (for instance, $101, $102) until your buy order is completely filled. In the end, your average purchase price may be higher than the expected $100, and this difference is called slippage.

On a technical level, when you submit a market order, the exchange automatically scans the order book and executes trades at the best available prices in sequence. If there is insufficient liquidity at a certain price level, the system will continue to scan downwards (when buying) or upwards (when selling).

Slippage is a common phenomenon in different markets

Slippage is particularly common in automated market maker (AMM) types and decentralized exchanges, and can sometimes exceed 10% of the expected price, especially for tokens with high volatility or low liquidity.

Rare but possible situations of positive slippage

Slippage is not always detrimental to traders. In certain extremely volatile markets, positive slippage may occur – meaning that your actual execution price is better than expected.

For example, if the market suddenly drops when you place a buy order, or if the market suddenly rises when you place a sell order, it may lead to executing your order at a better price. Although this situation is relatively rare, it can indeed occur in a highly volatile market.

acceptable slippage setting

Many trading platforms allow users to manually set the maximum slippage tolerance they are willing to accept. This parameter tells the system: “I allow the execution price to deviate from the expected price by no more than X%.”

Setting the slippage tolerance will directly affect the execution of orders:

• If you set a tolerance that is too low (e.g., 0.1%), the system will search for matching orders very strictly. The result may be that the order waits a long time, or even ultimately cannot be fully executed.
• If you set a high tolerance (such as over 5%), while it makes transactions easier, it also gives other traders the opportunity to perform sniping operations.

In decentralized trading, when your order is pending, other traders or bots may act first, using higher gas fees to buy the asset you want ahead of you, and then reselling it to you at a price you are willing to accept—this is known as front-running.

Practical Strategies: How to Reduce Negative Slippage

Although it is nearly impossible to completely avoid slippage, you can significantly reduce the risk by employing several strategies.

1. Place orders in batches rather than all at once.

Instead of placing a large order all at once, it is better to split it into several smaller orders. Carefully observe the order book to ensure that the quantity of each order does not exceed the available liquidity at that price level.

The benefits of doing this are: each small order has less impact on market prices, making it easier to execute at close to the same price, resulting in lower overall costs.

2. Fully assess on-chain costs

If you trade on a decentralized exchange, you must consider the blockchain transaction fees. The gas fees on certain networks during peak times can be quite substantial, even enough to eat up all your trading profits.

Before placing an order, calculate: transaction spread + trading fees = total cost. If the total cost exceeds the expected return, you should reconsider whether this trade is worth it.

3. Prioritize high liquidity markets

When you have a choice, try to operate in markets with high trading volume and good depth. The bid-ask spread in high liquidity markets is narrower, and the slippage risk is lower.

Avoid making large transactions in low-cap cryptocurrencies, newly listed assets, or trading pairs with very low trading volumes.

4. Use limit orders instead of market orders

Limit orders are only executed when the specified price or a better price is reached. While the execution time may be longer, you have complete control over the final execution price, and there is no slippage risk at all.

Compared to market orders' “immediate execution,” the limit order's “execute at price” strategy is more beneficial for protecting funds.

Summary

When making decisions in cryptocurrency trading, the impact of the Bid-Ask spread and slippage should not be underestimated. Even for small-scale trades, the effects of these factors can accumulate, but in large transactions, they often determine the success or failure of the trade.

Especially when trading in the decentralized finance space, understanding the slippage mechanism is fundamental. Lacking knowledge in this area, you can easily become a victim of front-running or excessive slippage, resulting in the loss of profits that could have otherwise been retained.

Remember: the market will not spare you just because you do not understand these concepts. Actively learning and practicing this knowledge is the only way to become a smarter trader.