Trading Crash Course | What Is Slippage? How To Avoid It in Trading

[TL;DR]

- Slippage is a situation in which traders receive different trade execution prices than initially expected.

- Slippage can either be positive or negative.

- A positive slippage gives the trader a better price than expected, while a negative slippage results in a loss.

- Chances of Slippage can be minimized by trading on highly liquid markets and those with low volatility.

- Other ways to minimize the risk of Slippage include using limit orders, slippage tolerance and breaking up trades.

- Slippage tolerance is the percentage of an order's transaction that market participants set on trade to reduce chances of Slippage.

An Overview

Investing in cryptocurrencies is among the best investment opportunities of the century. But there are numerous risks associated with investing in cryptocurrency. Prices are notoriously unstable. Security protocols are flawed, and hackers and scammers are constantly on the prowl, digging in for any security flaws that might allow them to loot funds.
Also, the crypto winter of 2022 has demonstrated that the crypto financial ecosystem still has serious structural vulnerabilities.

What is Slippage?

Slippage is the difference between the projected price of a trade and the main price at which the trade is completed. Slippage takes place when traders have to receive a different price than what they originally intended due to a change in price between the time the order comes into the market and the completion of a trade.
The difference in price could be zero, positive or negative, depending on the direction of price movement and whether the trade is a buy or sell or the trade is for opening or closing a position.

Whilst traders may receive a non-favourable price difference than projected; they might also receive a better price. Therefore, Slippage can be of two types; positive or negative.
A positive slippage happens when a trade is executed at a favourable price than what was expected, while a negative slippage describes when an order is completed at a worse price than what was expected.

Why Slippage Occurs

Slippage is frequent and usually occurs when the market is extremely volatile or when the market liquidity is low.

High Volatility
Slippage is most prevalent during periods of high volatility when market orders are employed. In a volatile market, price movements and change happen quickly. It takes some time for transactions to make it on-chain after initiation. Therefore, the final price of an asset may change during the time gap, resulting in Slippage.

Thin Liquidity
In a situation where a trader wants to purchase or sell Crypto at a specific price. The order might not be completed at this price due to thin liquidity on the other end of the trade. To complete the order, the trade would have to execute at a price with enough liquidity. This process might lead to a price significantly different from what the trader had projected.

How Does Slippage Work?

When an order is completed, the security is bought or sold at the most favourable price provided by an exchange or other market maker. This either gives trading results that are more favourable (positive), equal to or less favourable (negative) than the intended execution price. Positive and Negative Slippage significantly works in various ways.

For a buy order, positive Slippage is when the actual price is lower than projected, thus giving traders a favourable buying rate. Negative Slippage is when the actual price is higher than projected, giving traders an unfavourable buying rate.

For a sell order, positive Slippage is when the actual price is higher than projected, thus allowing traders to make more profit from a sale. Negative Slippage is when the actual price is lower than projected, leading to incurred losses for traders.

Furthermore, in Crypto trading, traders are usually allowed to set the percentage of the order's transaction value that they think is an acceptable and low-risk slippage cost. This percentage is known as slippage tolerance. The trade will not be carried out if the actual transaction's value goes beyond the slippage tolerance set by a trader.

How to Avoid Slippage in Trading

Trade in markets with low volatility and high liquidity
Low-volatility markets are marked by smooth price action, which means that the price changes are not chaotic. Conversely, highly liquid markets have a lot of active participants on both sides, which increases the chances of an order being completed at the projected price.

Trading within this period of low volatility and high liquidity can minimize your exposure to Slippage.

Slippage Tolerance
Slippage tolerance is the percentage of an order's transaction which Crypto traders set on trade to lower the risk of Slippage.

If the market stays within this percentage range, it will be executed at the requested price. However, if the price moves outside this range, the transaction will be automatically reverted.

Use limit orders
Slippage happens when a trader uses market orders to enter or exit trading positions. For this reason, using limit orders instead of market orders is one of the key strategies for avoiding the risk of Slippage. This is because limit orders are filled at pre-set prices or better ones, thus removing the possibility of negative Slippage, which can arise when using market orders.

Break up Large Trades
If traders want to buy or sell cryptocurrency in significant and market-moving size, another strategy might be to break up the transaction into smaller bits. By breaking a large trade up into several smaller ones, the trader can minimize their market impact and possible losses due to Slippage.

Final Thought

Slippage is a frequent occurrence for most crypto traders when the market price does not meet the intended price during a transaction.
It is almost impossible to completely avoid Slippage because it happens during market volatility or when there is low liquidity. Instead, traders can minimize Slippage occurrences by avoiding times known for high volatility. Employing other ways to minimize Slippage, such as setting limit orders and using a fast broker.

Generally, having basic knowledge of the concept of slippage and slippage tolerance in Crypto will help traders execute better trading strategies.



Author: Gate.io Observer: M. Olatunji
* This article represents only the views of the observers and does not constitute any investment suggestions.
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