Comprehensive Guide to Crypto Slippage

What Is Slippage in Crypto?

Slippage occurs when a trader ends up buying or selling an asset at a different price than what they had originally intended. In the fast-moving cryptocurrency markets, conditions can change rapidly between the time an order enters the market and when the order actually gets executed, resulting in the trader receiving a different price than expected.

Crypto slippage can be either positive or negative. While traders may receive a less favorable price than expected (negative slippage), they might also get a better price than anticipated (positive slippage). Understanding this phenomenon is crucial for anyone participating in cryptocurrency trading, as it directly impacts trading costs and profitability.

Whether slippage occurs or not depends largely on the type of order placed in the market. If a trader places a limit order, they agree to buy or sell a set amount at a set price subject to liquidity availability. The upside of limit orders is that they guarantee no slippage, as the trade will only execute at the specified price or better. The downside is that it may take longer to fill a limit order, or the order may not get filled at all if market conditions don't meet the specified price. Slippage typically occurs when traders attempt to buy and sell assets at the available market price by placing a market order, which prioritizes execution speed over price certainty.

Volatility and Low Liquidity — Dual Drivers of Slippage

Slippage can occur in the trading of all asset classes, but is notoriously problematic in cryptocurrency markets. This is due to the asset class' high volatility and often very thin liquidity conditions. Indeed, volatility and lack of liquidity are the two main causes of slippage in crypto trading.

Volatility

Volatility refers to the rapid and significant price movements that characterize cryptocurrency markets. A trader may enter an order expecting a certain price based on current market conditions. However, in a fast-moving market, prices could move significantly between the time that the trader enters their order and the time the order is executed. This price movement creates a gap between the expected price and the actual execution price, resulting in slippage.

For example, during major market events or news announcements, cryptocurrency prices can swing by several percentage points within seconds. If a trader places a market order during such volatile periods, the price may have moved substantially by the time the order is filled, leading to considerable slippage.

Thin Liquidity

Liquidity refers to the availability of buyers and sellers at various price levels in the market. Imagine that a trader wishes to buy or sell a cryptocurrency at a certain price. There might not be enough liquidity on the opposite side of the trade at this price to complete the order. In order to complete the order, the trade would need to execute at a price where there is sufficient liquidity available. This could result in a price that is significantly different from what the trader had expected.

Thin liquidity is particularly common in smaller cryptocurrencies or during off-peak trading hours. When a large order enters a market with limited liquidity, it can quickly absorb all available orders at the desired price level, forcing the remaining portion of the order to fill at progressively worse prices. This phenomenon is known as "walking the order book" and can result in substantial slippage for large trades.

How Does Crypto Slippage Work? An Example

To better understand slippage in practice, let's examine a concrete example. Say after seeing Bitcoin offered at $20,000 on a cryptocurrency exchange, a trader wishes to purchase one Bitcoin. They place an order to buy one Bitcoin at the market price. After a small delay, the trader realizes that they ended up paying $20,050 for one Bitcoin, slightly more than expected. This is an example of negative slippage, where the trader paid more than the initially displayed price.

The slippage may have occurred for several reasons. First, there might not have been enough liquidity on the exchange for them to buy an entire Bitcoin for $20,000. Perhaps the trader's buy order absorbed all the sell orders at $20,000 and then needed to match with sell orders at a higher price in order to find sufficient liquidity to complete the purchase.

Alternatively, the slippage could have occurred because market conditions changed between the time that the order was placed and executed. In other words, maybe other Bitcoin buyers managed to snap up the available liquidity at $20,000 first, or sellers at $20,000 suddenly pulled their offers in anticipation of higher prices. In competitive markets, order execution happens in fractions of a second, and multiple traders may be competing for the same liquidity.

On the flip side, had the trader secured one Bitcoin for under $20,000, that would have represented positive slippage. A sudden influx of sell orders at a slightly lower price could explain the positive slippage. For instance, if a large seller decided to dump Bitcoin at market price, creating temporary downward pressure, the trader's buy order might have filled at $19,950 instead of $20,000, resulting in a $50 benefit.

Now imagine the reverse situation. A trader sees the price of Bitcoin at $20,000 and wants to sell one Bitcoin directly at the market price. If they receive more than $20,000, this would represent positive slippage (perhaps due to aggressive buyers in the market). Conversely, if they receive less than $20,000, this would represent negative slippage (perhaps due to limited buy-side liquidity or sudden market downturn).

How to Calculate Crypto Slippage?

Slippage can be expressed in either a nominal (i.e., currency) amount or as a percentage, depending on what is most meaningful for the trader's analysis. In the above example, where a trader expected to buy one Bitcoin for $20,000 but ended up paying $20,050, the slippage is -$50 in nominal terms. In percentage terms, the trader ended up paying 0.25% more than expected, calculated as ($20,050 - $20,000) / $20,000 × 100% = 0.25%.

The formula for calculating slippage percentage is:

Slippage % = ((Actual Execution Price - Expected Price) / Expected Price) × 100%

For buy orders, positive slippage means paying less than expected (favorable), while negative slippage means paying more than expected (unfavorable). For sell orders, the opposite is true: positive slippage means receiving more than expected, while negative slippage means receiving less than expected.

What Is Slippage Tolerance?

Many trading platforms, including decentralized and centralized cryptocurrency exchanges, allow traders to set a preference as to how much slippage they will tolerate. In other words, they allow market participants to prevent any trades from executing if the slippage is higher than a certain percentage.

The definition of slippage tolerance is the difference in price between what the trader expects when placing an order and what they are willing to accept when the trade executes. Usually, trading platforms will express slippage tolerance as a percentage of the total trade value. For example, setting a slippage tolerance of 1% means the trader is willing to accept up to 1% price deviation from the expected price at the time of order placement.

Slippage tolerance serves as a protective mechanism. If market conditions move beyond the tolerance level before the order executes, the platform will automatically cancel the order rather than executing it at an unfavorable price. This prevents traders from experiencing unexpectedly large losses due to rapid market movements or liquidity issues.

Crypto Slippage on Decentralized Exchanges

Decentralized exchanges (DEXs) have some significant advantages over their centralized counterparts. Unlike their centralized peers, trading on a DEX doesn't require Know Your Customer background checks that can be exclusionary, offering greater privacy and accessibility to users worldwide. Additionally, DEXs allow users to maintain custody of their funds throughout the trading process, reducing counterparty risk.

However, one of the big drawbacks versus traditional cryptocurrency exchanges is that DEXs often face worse slippage. Why is this the case?

Smart contracts power trade execution on DEXs. That means, unlike on centralized exchanges where trades can be matched and executed almost instantaneously on the exchange's internal systems, a trade on a DEX doesn't process right away. Rather, there is a lag as the trade is processed on the blockchain, just as there is with any blockchain transaction. The transaction must be broadcast to the network, picked up by validators, included in a block, and then confirmed on the blockchain.

The longer delay between transaction confirmation and transaction execution means that there is a longer window for slippage to occur. During this time, other traders may execute transactions that change the liquidity pool composition, or market prices may move, resulting in your transaction executing at a different price than expected.

Additionally, DEXs typically operate using automated market maker (AMM) models with liquidity pools, rather than traditional order books. The pricing in these pools is determined by mathematical formulas, and large trades can significantly impact the pool's price curve, leading to substantial slippage.

Calculating crypto slippage on a DEX is exactly the same as on any other trading platform. For example, say you want to buy 500 USDC worth of ETH on a major DEX. The platform will show you an expected price in ETH based on current pool conditions. Most DEXs allow you to set a slippage tolerance and will also show you the minimum expected output of ETH if the maximum slippage is reached. This transparency helps traders understand the worst-case scenario before confirming their transaction.

How to Avoid Slippage on DEXs

The following are some of the methods that help traders avoid or minimize slippage when trading on decentralized exchanges.

Pay a Higher Gas Fee

To conduct a transaction on a blockchain network like Ethereum, users need to pay a fee to network validators. This is called the "gas fee" and it incentivizes network validators to either stake their crypto to secure the network (as in the case of proof-of-stake blockchains) or provide their computing power to secure the network (as in the case of proof-of-work blockchains). When a user submits a transaction to the blockchain, it joins a queue of other transactions waiting to be validated.

To reduce the problem of slippage on a decentralized exchange, a trader could take steps to speed up the rate at which their transaction is processed. To do this, they could choose to pay a higher transaction fee (gas fee) in order for their transaction to be pushed further forward in the queue. Validators typically prioritize transactions with higher gas fees, as they earn more from processing these transactions.

By paying a premium gas fee, traders can reduce the time their transaction spends waiting in the mempool, thereby reducing the window during which market conditions might change. This is particularly useful during periods of high network congestion or high market volatility when every second counts.

However, traders should weigh the cost of higher gas fees against the potential savings from reduced slippage. In some cases, the additional gas cost may exceed the slippage savings, making this strategy less economically viable.

Trade on Layer 2-Based DEXs

In the past few years, the majority of DEXs have been running on Layer 1 blockchain networks. For example, much of the trading that takes place on major DEX platforms has been powered directly by the Ethereum network. When the Ethereum network gets congested, this can slow down these trades and exacerbate the risk of slippage.

However, Layer 1 networks like Ethereum also have "scaling solution" blockchains built on top of them. One of the best-known examples is Polygon, which is a sidechain that runs parallel to Ethereum. Transactions are processed quickly on this network, as the processing does not happen on the main chain. Instead, transactions are batched and settled on the main chain periodically. Polygon is an example of a "Layer 2" protocol.

Thus, traders could opt to use a Layer 2-based DEX, which could mean faster transactions, less risk of slippage, and significantly lower gas fees. A trader could use platforms like certain DEX platforms built on Polygon, which offer near-instant transaction confirmation and minimal fees compared to Ethereum mainnet.

Other Layer 2 solutions include Optimism, Arbitrum, and zkSync, each offering different trade-offs in terms of security, speed, and decentralization. By trading on these networks, users can enjoy the benefits of decentralized trading with significantly reduced slippage risk.

Separately, traders can also adjust their slippage tolerance in most DEXs. A low slippage tolerance may prevent a trade from filling, as the transaction will be rejected if market conditions move beyond the tolerance level. But it will prevent unexpectedly large losses as a result of slippage. Finding the right balance between slippage tolerance and trade execution probability is a key skill for DEX traders.

How to Reduce Slippage on CEXs

Similar to DEXs, traders can also take several steps to reduce slippage when trading on traditional centralized cryptocurrency exchanges (CEXs).

Use Limit Orders

When trading on centralized/traditional cryptocurrency exchanges, traders can take a mixture of steps to minimize the risk of loss as a result of slippage. Firstly, a trader could utilize limit orders as opposed to buying at the market price. As explained earlier in the article, limit orders run the risk of not filling, but at the same time, never incur slippage.

A limit order specifies the exact price at which you're willing to buy or sell. The order will only execute if the market reaches your specified price (or better). This gives you complete control over the execution price, eliminating slippage entirely. However, the trade-off is that your order may sit in the order book for an extended period, or may never fill if the market doesn't reach your price.

For traders who prioritize price certainty over execution speed, limit orders are the ideal choice. They're particularly useful when trading large positions or during volatile market conditions when slippage risk is highest.

Trade During Periods of Low Volatility

Investors could choose to trade at times of the day which usually don't incur as much volatility. For example, it's advisable to avoid trading around the time of the European to U.S. market crossover or around the time when the U.S. market is open, as these periods typically see higher trading volumes and volatility. It's also advisable to avoid trading around the time of big market events like major economic data releases, central bank announcements, or significant cryptocurrency-related news.

Trading during quieter market periods, such as Asian trading hours or weekends, may result in lower volatility and more stable prices, reducing slippage risk. However, traders should be aware that lower volatility often comes with lower liquidity, which could potentially increase slippage for larger orders.

Monitoring market conditions and timing your trades accordingly can significantly reduce slippage-related losses over time.

Break Up Large Trades

If traders are looking to buy or sell cryptocurrency in significant, potentially market-moving size, another effective strategy might be to break up the transaction into smaller pieces. By splitting a large trade into a series of smaller ones, the trader may be able to reduce their market impact and potential losses due to slippage.

For example, instead of placing a single order to buy 100 Bitcoin, a trader might place ten orders of 10 Bitcoin each, spaced out over time. This approach, known as "order slicing" or "iceberg orders," helps to avoid depleting liquidity at any single price level and prevents alerting the market to your large position.

Many sophisticated traders and institutions use algorithmic trading strategies like TWAP (Time-Weighted Average Price) or VWAP (Volume-Weighted Average Price) to execute large orders with minimal market impact. These algorithms automatically break up large orders and execute them gradually over a specified time period, optimizing for minimal slippage.

How Much Should Crypto Investors Worry About Slippage?

Being aware of what slippage in crypto is, and how to mitigate its downside risks, is useful for all cryptocurrency market participants. However, the level of concern about slippage should vary depending on your trading style, position size, and investment horizon.

For a small-time crypto investor who conducts transactions on an irregular basis and is looking to hold their crypto for a long time (a "HODLer"), it probably doesn't matter that much if their slippage is -0.5% instead of -0.25%. This small amount would pale in comparison to the long-term returns of the investment. If you're buying Bitcoin or Ethereum to hold for several years, a few dollars of slippage on your entry price is unlikely to significantly impact your overall returns.

However, to larger scale investors, a -0.25% to -0.5% loss could actually amount to quite a substantial sum of money. For instance, on a $1 million trade, 0.5% slippage represents $5,000 in additional costs. For institutional investors or high-net-worth individuals trading in significant size, these costs can quickly add up to hundreds of thousands or even millions of dollars annually. So, it might be worth their time and effort to try to minimize this as much as possible through careful order execution strategies.

Meanwhile, cryptocurrency traders who conduct transactions with high frequency, such as day traders and scalpers, would also do well to take every step possible to minimize losses related to slippage. A -0.25% loss multiple times a day can quickly eat into profits and turn a potentially profitable trading strategy into a losing one. For traders who aim to profit from small price movements, slippage can be the difference between profitability and losses.

Additionally, traders using leverage should be particularly cautious about slippage, as even small percentage losses can be magnified by leverage, potentially leading to margin calls or liquidations.

In summary, while all traders should understand slippage, the effort invested in minimizing it should be proportional to your trading frequency, position size, and investment strategy.

FAQ

What is Slippage in Cryptocurrency Trading?

Slippage is the difference between the expected price and actual execution price when trading cryptocurrencies. It occurs due to market volatility and liquidity changes, causing you to pay more or receive less than anticipated. Slippage is especially common in highly volatile markets.

Why does slippage occur in cryptocurrency trading?

Slippage occurs due to market volatility and insufficient liquidity. The price can change between when you initiate a trade and when it executes, causing the actual execution price to differ from your expected price. This is especially common in highly volatile markets with lower trading volume.

How does slippage affect my trading profits?

Slippage directly reduces your trading profits by creating a gap between expected and actual execution prices. Larger transaction amounts experience greater slippage impact, potentially causing significant losses that exceed visible trading fees and substantially diminish your overall returns.

What is the difference between slippage in spot trading and futures trading?

Spot trading typically experiences smaller slippage due to stable market conditions and higher liquidity. Futures trading often has larger slippage due to higher volatility, lower liquidity, and leverage effects that amplify price movements.

How to avoid slippage by setting limit orders?

Set a limit order to specify your exact desired price. This prevents trades from executing above or below your target price, eliminating slippage caused by market volatility and price fluctuations during order execution.

What are effective slippage avoidance strategies in highly volatile markets?

In volatile markets, improve network efficiency and computer specs to reduce system slippage. Select high-liquidity trading pairs and set reasonable stop-loss levels. Use limit orders instead of market orders to control execution prices and minimize slippage impact.