CoinMarketCap Academy looks at bid-ask spread in crypto trading, the difference between bid-ask spread and slippage, and how to minimize its impact on your trading.
Recently, we dove into the different types of orders in crypto and the fees you pay when trading. In this article, we expand on this subject by diving into one of the hidden costs in trading: bid-ask spread.
In trading, there are many aspects to be aware of at all times - so much so that some of the things can fly under your radar. The bid-ask spread is one of those things that many people are unaware of, even though it can have significant consequences for your trading.
Did you ever intend to buy Bitcoin, only to end up paying a significantly higher price than you thought you would? Well, this might have been because of the bid-ask spread.
Before diving into the technical questions like what this spread means for your trading and how you can minimize its negative impact on your profitability, let’s understand what an order book is!
What Is an Order Book?
Order books are a database of sorts that gathers all the available liquidity and displays it in a simple manner. It displays all buy and sell orders, giving traders insights into the available liquidity, demand and supply. Order books show the price, the size of orders in the asset you are trading, and the value of those orders in terms of the other asset selected in the pair. Buy orders (or bids) are shown in green, whereas sell orders (or asks) are shown in red.
Order books rapidly update as orders and liquidations are executed, and new orders are added to the book.
What Is a Bid-Ask Spread?
If you look at the order book above, you can see that the highest bid ($22,346) and lowest ask ($22,347) are not the same. Rather, there is a gap of one dollar. This gap is called the bid-ask spread. To put it in trading terms, the bid-ask spread is the gap between the highest bid and lowest ask in the order book. Put another way, it is the difference between the minimum price at which someone is willing to sell an asset and the maximum price someone is willing to buy that asset.
In most crypto exchanges, the bid-ask spread comes down to supply and demand dynamics in the order book, and the spread is generally quite tight. In these exchanges, the bid-ask spread might still expand from time to time, especially when the market behaves erratically or uncertainty is high – and liquidity dries up as a result.
With high-volume markets, the bid-ask spread is generally smaller, whereas lower liquidity markets have a bigger spread. This comes down to the lack of competition between buyers and sellers: the more the participants, the tighter the spreads is.
There are numerous resources available that monitor the average spread per exchange or even trading pair, but you can also calculate the spread yourself. Simply subtract the highest bid price from the lowest ask price. For example, if the highest bid on Ethereum is $1,570 and the lowest ask is $1,570.50, the spread is 50 cents.
Why Does the Bid-Ask Spread Matter for Crypto Trading?
The bid-ask spread can have a big impact on your trading, especially over longer periods of time. These small differences between buying and selling prices reduce your profit potential, as you’re buying at higher prices and selling at lower prices than you ideally would. Every transaction eats a tiny portion of your profits, which, over time, amounts to a sizable amount of money. Let’s look at an example.
Imagine you are trading an imaginary coin "ABC," where the fair market price is $0.35, and the spread is $0.02. In this situation, you buy ABC at the lowest ask price of $0.36. At this point in time, your best available option to sell ABC is $0.34 (highest bid price). In other words, the price will have to move up two whole cents, or approximately 5% just so you can get out at break even. See the problem?
Especially when trading with a high frequency, bid-ask spread can really mess up your profitability.
Bid-Ask spread vs Slippage
Bid-Ask spread and slippage are often confused with one another, but they are fundamentally different. While studying bid-ask spread merely requires you to look at the highest available bid price and compare that to the lowest available ask price – traders have to take into account the size of these bids and asks in order to get a picture of what slippage is going to be like.
Most of the time, slippage happens because there is insufficient liquidity to fill an order. For example, if you would market buy 100 Bitcoin on the open market, you would push the price up by a significant margin. In essence, slippage is when your order is filled at a much higher price than you expected.
Because slippage has to do more with liquidity, smaller traders generally don’t encounter this problem until they start trading pairs with limited liquidity. However, for large traders, it can become a real issue. Luckily, most exchanges have anti-slippage protection tools in place that cancel an order if it would be filled at – for example – 10% above the current market prices.
How To Minimize the Impact of Bid-Ask Spread and Slippage?
One way to make sure these problems have less impact on your trading is by minimizing the number of market orders you send into the order book, as these are filled at the best available price.
Also, by using limit orders instead, you can set a limit to the price you are willing to pay or to how little you are willing to accept.
Closing Thoughts
In sum, bid-ask spread and slippage are important things to be aware of. They vary per exchange and trading pair, and may even fluctuate as market conditions change. Both spread and slippage can eat away at your profits, especially when you’re trading with a higher frequency.
Writer’s Disclaimer: This article is based on my limited knowledge and experience. It has been written for educational purposes. It should not be construed as advice in any shape or form. Please do your own research.
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