Slippage and Price Impact Explained

slippage and price impact

We discuss the concepts of slippage and price impact. These are important topics to understand for anyone trading financial instruments, such as stocks, bonds, crypto and derivatives. Both slippage and price impact are important to consider when trading, as they can affect the costs and potential returns of a trade.

What is slippage?

Slippage is the difference between the expected price of a trade and the price at which the trade is actually executed. It occurs when the market moves against a trader's position while an order is being processed, resulting in the trade being filled at a different price than expected. Slippage can be either positive or negative, depending on whether the trade is filled at a better or worse price than expected.

Slippage, take from IG UK

What causes slippage?

There are several factors that can cause slippage, including market volatility, the size of the trade, and the type of order being placed. For example, a trader may experience more slippage when placing a market order (which is filled at the current market price) during times of high volatility, as the market price may change rapidly. On the other hand, a limit order (which allows the trader to specify a maximum or minimum price at which they are willing to trade) may experience less slippage, as the order will only be filled if the market price reaches the specified limit.

Slippage can have a significant impact on a trader's profits and losses. If a trade is filled at a worse price than expected, it can result in a larger loss than anticipated. On the other hand, if the trade is filled at a better price than expected, it can result in a larger profit. It is important for traders to consider the potential for slippage when placing orders and to adjust their risk management strategies accordingly.

There are several ways that traders can try to minimise the impact of slippage on their trades. For example, they can use limit orders instead of market orders, or they can place their orders during times of lower market volatility. Some traders also use algorithms or trading software that are designed to minimise slippage by adapting to market conditions in real-time.

Using liquidity charts to determine trade volume can help aid in trading at times of less slippage

Slippage in DeFi

In DeFi, slippage can be especially significant due to the decentralised nature of the market. Unlike traditional financial markets, which are centralised and regulated by a single entity, DeFi markets are decentralised and operate on a peer-to-peer basis. This can lead to higher levels of volatility and lower liquidity, which can increase the likelihood of slippage occurring.

So, what does this mean for DeFi traders? It's important to be aware of the potential for slippage and to factor it into your trading strategy. This may involve setting wider bid-ask spreads to account for the possibility of slippage, or using limit orders rather than market orders to try and reduce the impact of slippage on your trades.

It's also worth noting that some DeFi protocols have implemented measures to try and reduce the impact of slippage on trades. For example, some protocols use "liquidity pools" to provide a more stable and liquid market for traders. By pooling the assets of multiple users, these protocols can increase the overall liquidity of the market and reduce the likelihood of slippage occurring.

Liquidity pools shown on Curve
Calculated slippage shown on Curve

Overall, slippage is an important consideration for DeFi traders to keep in mind. While it can be difficult to predict or avoid entirely, being aware of the potential for slippage and taking steps to mitigate its impact can help traders make more informed decisions and potentially increase their returns. Slippage can have a significant impact on a trader's profits and losses, and traders can take steps to minimise its impact by using limit orders, trading during periods of lower volatility, and using algorithms or trading software.

What is price impact?

Price impact is the difference between the current market price and the price you will actually pay when performing a swap on a decentralised exchange. It refers to the change in price that occurs as a result of the trade being executed. Price impact can be either positive or negative, depending on whether the trade pushes the price up or down

Price impact tells how much less your market taker order gets filled because there is not available liquidity. For example, if you are trying to buy 5000 USD worth of BNB token, but there isn’t available liquidity you end up with 4980 USD worth of token at the end of the trade when you pay 5000 USD. The missing fill is the price impact. It can be expressed as USD value or as percent of the trade amount.

Price impact depicted on ParaSwap

What causes price impact?

There are several factors that can influence the price impact of a trade. The size of the trade is one of the most important factors, as larger trades are more likely to have a greater impact on the market price. The liquidity of the asset being traded is also a factor, as more liquid assets are generally less prone to price changes as a result of trades. The overall market conditions, including the level of volatility and the supply and demand for the asset, can also affect price impact.

There are several strategies that traders can use to minimise the price impact of their trades. For example, they can use algorithms or trading software that break up large orders into smaller pieces and execute them over a period of time, rather than all at once. This can help to reduce the impact of the trade on the market price. Traders can also use limit orders, which allow them to specify a maximum or minimum price at which they are willing to trade, rather than market orders, which are filled at the current market price.

Price impact for DeFi

In DeFi, price impact can be significant for decentralised markets similarly to slippage. It's important to be aware of the potential for price impact and to factor it into your trading strategy. This may involve using larger order sizes for highly liquid assets or smaller order sizes for less liquid assets to try and reduce the impact of your trades on the market.

Price impact shown on PancakeSwap

Overall, price impact is an important consideration for DeFi traders to keep in mind. While it can be difficult to predict or avoid entirely, being aware of the potential for price impact and taking steps to mitigate its impact can help traders make more informed decisions and potentially increase their returns.

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