How does slippage, market depth and liquidity affect your profits?

When trading cryptocurrencies, market depth, slippage and liquidity are among several frequently mentioned terms which could affect an investor’s cost and final profits. Therefore, understanding how these three terms affect your earnings is a crucial lesson for every trader. 

What is market depth?

The depth of a market is one of the major factors to be considered when selecting an exchange in which to trade cryptocurrencies.  

Market depth refers to the market liquidity for a security based on the number of standing orders to buy (bids) and sell (offers) at various price levels. In addition to price levels, market depth considers the order size, or volume, at each price level. 

In other words, if an exchange has a vast base of active users who can provide a large number of standing orders on the book, this exchange is considered to have sufficient market depth or liquidity.

What is the slippage?

Slippage is another factor that should be considered when choosing an exchange. Slippage is the difference between the final execution price and the ask price of an order — slippage should be viewed as an aspect of transaction costs that cannot be avoided. 

 Slippage can be both positive and negative. Positive slippage occurs when the execution price is higher than the initial ask price; should the execution price be lower than the ask price, such a situation would be known as negative slippage.

For instance, assume you are closing your long Bitcoin (BTC) position when the market is trending upward and set an ask price of US$25,000. Under such market conditions, the final execution price could exceed your ask price and your position is closed at US$25,500 instead. This additional US$500 difference is known as positive slippage.  

The reverse could also happen, especially during a down trending market, where the final execution price is lower than the ask price. In such a case, the difference between the ask and final execution price would be known as negative slippage. 

How does market depth affect slippage? 

 Trading at an exchange with sufficient market depth could dramatically lower the costs incurred when negative slippage occurs. In exchanges with sufficient market depth, setting an ask price that is close to the market price will usually result in prompt order execution, due to the large number of order takers.  

On the other hand, trading at an exchange with few r users could result in significant differences between the ask and final execution prices. Orders could often not be fulfilled at their ask prices, resulting in higher slippage costs.  

Market depth is also closely related to liquidity. Exchanges with enough liquidity ensures trades can be fulfilled quickly at fair prices. 

Can slippage be avoided?

The answer is, unfortunately, no. Some measure of slippage will take place no matter which platform you choose or which assets you choose to trade, be it cryptocurrencies, stocks or futures. However, users can choose to minimize negative slippage by choosing to trade on exchanges with sufficient market depth and liquidity.

Beginners who are in the process of making such a choice should join a leading cryptocurrency exchange such as Huobi Global. Current bearish sentiments have steered users toward steeper risk aversion measures, and choosing to conduct trades in a renowned exchange with high trading volumes is one of the steps that can be taken to mitigate risk.