What is Slippage in Crypto?
Slippage is the difference between the average purchase or sale price for a trade and the initial selling or market price. Slippage refers to the changes in the presiding price of an asset in the course of the execution of a trade request.
Key Takeaways
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Slippage in trading is the variation between the initial or set buy or sale price and the actual or average price at which the whole or a greater portion of the trade was executed at. Slippage cause changes in the calculated number of tokens to be bought or purchased.
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Slippage can be positive or negative depending on its impact on the final trade results. In a positive scenario, a buyer ends up realizing more tokens as the average purchase price becomes lower than the presiding selling price. The reverse is the case in a negative slippage scenario.
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A major cause of slippage on centralized exchanges is the liquidity density and the spread across the order prices. Slippage on decentralized exchanges can be caused by other reasons, including tax contracts on the token’s smart contract.
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Slippage on any trading platform can be controlled by modifying trading parameters or using slippage control facilities where they are available. Decentralized exchanges allow users to set up the maximum allowed slippage for their trades using the slippage modification feature.
Whether you are trading some new meme coin with a tax contract or just trying to push your trades over the queue, slippage meddle with your final trade results, but they are not only limited to decentralized exchanges. Slippage is also present in centralized cryptocurrency exchanges as well and also mainstream trading platforms.
In centralized exchanges, it results when orders at a certain price level are exhausted and the trade progresses to completion by purchasing or selling assets at higher or lower price levels. This sequential progression in trade execution causes a gap between the initial or expected price and the average selling or buying price.
On decentralized exchanges, this gap can be created by insufficient liquidity or set taxes in the token’s smart contract. This ‘gap’ is slippage, calculated in percentage. Minimizing slippage involves certain technical and procedural tweaks, some of which will be discussed in this article.
The average decentralized exchange user has at least once changed the percentage slippage tolerance before proceeding with their trade.
So, what is slippage in crypto and how can you tame its effects?
How to Calculate Slippage in Crypto
As mentioned above, slippage is the simultaneous price changes in the course of executing an asset sale or purchase.
If a limit is not placed on the selling or purchase prices for a trade, the trade request will continue across the different order levels until the purchase limit is exhausted or the order book is completely cleared. The former is the most common outcome and this means that the trade is broken up and the portions executed at different prices. This applies to buy and sell requests.
The actual price for a trade is obtained by taking an average price for the complete trade, considering the percentage of the trade completed at each price. Where the resultant average price is different from the market price at the time of creating the order, slippage is said to have occurred.
Slippage percentage is calculated by obtaining the difference between the initial market price and the calculated average purchase (or sale price) and dividing this by the initial price and multiplying by 100.
For a purchase transaction:
Percentage Slippage = ((initial market price – average purchase) / initial market price) * 100
If the percentage is a positive figure (say 3%, 10%, etc) this is known as positive slippage. If the percentage is a negative figure (say -3%, -10%, etc) this is known as negative slippage.
For a sale transaction:
Percentage Slippage = ((average sale price -initial market price / initial market price) * 100
If the percentage is a positive figure (say 3%, 20%, etc) this is known as positive slippage. If the percentage is a negative figure (say -3%, -20%, etc) this is known as negative slippage.
Types of Slippage in Crypto
Positive slippage
In positive slippage, the percentage slippage is a positive figure. In a sale transaction, positive slippage means that the trade was completed at a price higher than the market price at the time the trade was executed, but this scenario is not common. More common is positive slippage for purchase transactions; the trader in this case ends up buying more assets for a cheaper price than intended.
Negative Slippage
If the average sale price for a trade is lower than the initial market price, this is known as negative slippage. The seller ends up selling their assets at a price lower than the market price. For purchase transactions, negative slippage occurs when the trader is forced to buy the asset at an average price higher than the actual market price. The trader ends up buying a lesser number of tokens or spending more to acquire the intended number of tokens.
Why Does Slippage Occur?
Slippage occur basically because the order book is unable to satisfy the trade request at the initial price and resorts to going down or up the book to complete the trade. This is only possible where the trade has no set limits and the order is free to run along the books. Slippage can occur due to:
Insufficient Liquidity
Liquidity for a traded asset is the amount or density of buy and sell orders at any given time. This delineates the value of trade that can be executed without the order books changing significantly. If the liquidity is sufficient, significant trades will be completed with minimal changes to the order book. Where this is not the case, significant slippage could occur.
Uneven and Irregular Order Book Spread
Even in the presence of a sufficient order for a trade, the spread could also cause significant slippage to occur. This is more common in centralized exchanges. For instance, there could be only a few orders at the current market, and the majority of orders are concentrated at other price levels which differ significantly from each other. The uneven and irregular spread means the orders at the initial price get filled while the trade progresses to other levels for completion, causing significant slippage.
Presiding Market Conditions
In periods of high volatility, the order books could experience some drastic changes due to an imbalance between the demand and supply. As more buy orders flow into the market in times of high demand, there is a high possibility of slippage occurring as the order books are cleared and the price moved to even higher levels. The same principle applies in cases where there are too many sale requests.
On decentralized exchanges, setting a high slippage tolerance allows the protocol to fast-track trades in a volatile market condition while the trader pays the ultimate fee of losing some of their assets to slippage and paying more for the trade. This leads to a practice known as front-running.
Smart Contract Taxes
New developments in the smart contract and DeFi space make it possible for smart contract token creators to insert a taxation clause in the token’s contract, which is enforced on transfers and trades in decentralized exchanges. The tax clause allows the state machine to deduct a certain percentage of the transacted tokens for every transfer of trade.
To enforce this on decentralized exchanges, the trader must adjust the slippage tolerance to a level equal to or above the total smart contract tax. That is, if the total tax clause to a token is 12%, the trader must set the slippage tolerance to at least 12%. So, what is slippage tolerance in crypto?
What is Slippage Tolerance in Crypto?
Slippage tolerance is the percentage of your traded tokens you would be willing to give up to slippage. It makes up the trading parameter on decentralized exchanges, and some centralized exchanges have also developed a similar feature to allow traders to modify the tolerance level for slippage in Market and Stop Market trading options.
For non-taxed smart contract tokens, the slippage tolerance feature enables a trader to set the maximum percentage of the total value of their trade they are willing to lose in return for a fast-tracked trade. If high enough, the protocol proceeds to jump their queue and execute their trades ahead of other requests in the mempool. The trader also pays more in fees for high-slippage trades.
Slippage on Decentralized Exchanges
In comparison with centralized exchanges, decentralized exchanges are powered by different technology and are designed for instant exchange of crypto assets. The Automated Market Makers (AMM) technology satisfies trade requests from liquidity pools and not from a spread order book. Slippage on platforms like this take another form but are caused by the same reason: liquidity and demand. Smart contract taxes are particular to decentralized exchanges as well.
When the liquidity pool doesn’t hold a sufficient quantity of the paired tokens, every trade results in a significant shift in price, and the average selling or buying price is significantly different from the initial market price. When the demand for any of the tokens in the pair spikes, the transactions are held in a mempool and trades are satisfied sequentially. To speed up a trade, traders can increase the slippage tolerance to allow the protocol to speed up their own trade requests as described earlier.
If the traded token has a tax clause, the slippage must be set to give the state machine enough room to deduct the taxes as stipulated in the smart contract agreement.
How to Minimize Slippage in Decentralized Exchanges
Here are a few things you can do while using decentralized exchanges to avoid losing too much to slippage.
Set a Tolerance Level for Slippage
You can limit the slippage for each trade by setting a maximum slippage tolerance as it applies to your trade. This feature is available on most decentralized exchanges.
Avoid Trading Tokens With Low Liquidity
Low liquidity is the leading reason for slippage on centralized and decentralized exchanges. While trading on decentralized exchanges, check out the available liquidity in the pool for the asset you wish to trade. Tools like GeckoTerminal show the liquidity available for every tracked pair. For a good experience, ensure the available liquidity is up to at least 30% of the asset’s total market capitalization. This will also depend on the quantity of your trade. For high-value trades, the available liquidity should be even higher than this.
Also, consider the impact of your trade on the price; this is usually presented by the DEX. If your transaction has a high impact on the market, your sale transaction will also have a relative impact. This means negative slippage for both buy and sale transactions. Consider if this is healthy for your investment before proceeding with the trade.
Strategically Trading Highly Active Pairs
When trade requests for an asset on DEX spikes, the volatility and the influx of transactions causes abrupt price chances and on-chain congestion respectively. In this scenario, trading the asset is likely to involve high slippage and the need to increase the slippage tolerance. If you are willing to manage the consequences of not taking part in the trade at that time, then consider not trading the asset until the demand or sale cools down in order to lower slippage.
Consider the Tax Provisions for the Tokens You Wish to Trade
Check if the token has tax clauses and what the tax percentage looks like. Include this in your investment plans and consider the impact of the loss to taxes on the expected profitability of the asset. If favorable, you can proceed with your trade. If not, consider other strategies or trading non-taxed tokens. This is not financial advice.
Slippage on Centralized Exchanges
While most decentralized exchanges use AMMs and liquidity pools, centralized exchanges run the traditional order book system which is relatively more transparent. Taking a look at the order book and trading history, the reasons for slippage on centralized exchanges can be easily identified.
The order book group trade requests according to the set buy and sale price, and execute the trade once the set parameters are satisfied. When a spot trader uses the Market or Stop Market option to make their trades, the trade is executed at presiding market prices. The trade ultimately proceeds to completion by trading at the different levels of the order book. This incurs slippage if the liquidity at the initial market price is insufficient for the trade.
Centralized exchanges do not recognize the tax clauses on smart contracts and therefore do not apply an automated deduction to trade requests. Slippage on centralized exchanges, therefore, result mainly from insufficient liquidity and uneven order book spread.
How to Limit Slippage on Centralized Exchanges
While using centralized exchanges, here are a few things you can do to manage slippage.
Consider the Available Liquidity and Spread on the Exchange
Before making a trade request, ensure to take a look at the order book and consider the available liquidity and the spread pattern across the different price levels. Relate these findings to the value of your trade and your investment plans. Ensure that these conditions are fit for you. If not, you can try taking a look at other exchanges where the asset is listed and choose the one with the best liquidity and order spread for your trade.
Use Limit Orders
Limit orders keep traders in control of their traders. When there are uncertainties around the order book, a good way to manage slippage is by using limit orders to set price parameters. Trades will be executed according to the setting and trades will be halted once the conditions stray away from the set point or intervals.
Break down the Trade
More than anyone else, slippage affect high-value traders. When trading a huge amount of an asset, a good way to manage slippage better is by breaking down the trades into smaller quantities, such as ones that can be satisfied by the liquidity at the current market price, then take a break to consider the available liquidity after each trade and the impact the next trade has on your investment. If positive or manageable, the trader can proceed with making more sales or purchases at presiding conditions or holding off to allow the orders to build up again.
Strategically Trading Highly Active Pairs
When in high demand or high sale conditions, the order books of assets could get tricky. If a trader must trade during periods like this, more caution is advised. Consider using limit orders to or only trade quantities that can be satisfied by the liquidity available at the market price order book level. This could also be hard to catch due to the raining buy or sell orders.
Use Slippage Tolerance Where Possible
Unlike decentralized exchanges, slippage tolerance modification features aren’t widely available in centralized exchanges at the time of writing. Only a few exchanges have introduced this feature on their platform while the rest explore the possibility of adding this feature. Where this is available, it is recommended that traders use it and set up the maximum slippage they are willing to allow for each trade.
Final Thoughts
With the raging expectation of quick gains on your meme coin trade, setting up a slippage tolerance level of up to 15% is pretty easy. With a little research into the working principles of this and what it means for the traders, investors in volatile crypto assets accept the minimum slippage levels that allow their buy transaction to go through. On the other hand, there are more concerns when attempting to sell a token and take profit or stop loss.
Even on centralized exchanges, users can incur a significant percentage of slippage, especially in low-volume exchanges. But this could also be profitable where the presiding demand and supply conditions meet poor liquidity and irregular spread.
The effect of slippage ranges from mild to serious and is inevitable at times, leaving traders torn between managing the consequences of negative slippage and forfeiting a trade. The latter is the only absolute solution to slippages where they exist.
We have discussed a few strategies to ameliorate the effect of high slippage or bypass them, but this might not apply in every situation and it is recommended that every trader develops a personal strategy for handling slippage. Also, note that the contents of this article are only educational and not financial advice. Always do your own research.
Joel is deeply interested in the technologies behind cryptocurrencies and blockchain networks. In his over 7 years of involvement in the space, he helps startups build a stronger internet presence through written content. Follow the author on Twitter @agboifesinachi
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