Price Impact vs Slippage: Executing Efficient Trades in DeFi

Price impact and slippage are often used interchangeably. 

However, they actually refer to different concepts, and understanding the difference is essential to executing efficient trades.

Price Impact vs Slippage

Price impact and slippage are related concepts in crypto trading, but they refer to different things.

Price impact refers to the effect that a trade or order has on the price of a cryptocurrency. When a large trade or order is placed, it can cause the price of the cryptocurrency to move up or down, depending on whether the trade is a buy or a sell. Price impact is often measured as a percentage of the current market price of the cryptocurrency.

Slippage, on the other hand, refers to the difference between the expected price of a trade and the actual price at which the trade is executed. Slippage can occur due to market volatility, order size, liquidity, and network congestion. When slippage occurs, the trader may end up paying a higher price to buy or receive a lower price to sell than they anticipated due to the market conditions.

In other words, price impact is the cause of slippage. When a large trade or order is placed, it causes the price of the cryptocurrency to move, which can result in slippage if the trade is not executed at the expected price. While price impact is the measure of the effect that a trade has on the price, slippage is the measure of the difference between the expected price and the actual price of the trade.

What is Price Impact?

Price impact in crypto refers to the effect that a trade or order has on the price of a cryptocurrency. When a large trade or order is placed, it can have a significant impact on the price of the cryptocurrency.

For example, if a trader wants to buy a large amount of a cryptocurrency, they will have to buy from the order book, which may cause the price to go up due to the increased demand.

Similarly, if a trader wants to sell a large amount of a cryptocurrency, they will have to sell into the order book, which may cause the price to go down due to the increased supply.

Take this order book as an example:

This pair has over 2,730 ETH worth of liquidity in each blue bar.

Meaning you'd have to have a large amount of ETH to chew through the liquidity to move the price.

Compare that to this order book:

This pair has only 320 ETH in each blue bar.

The price ratios would move much quicker in this order book than the other one.

Price impact is an important consideration for traders, particularly those who are executing large trades. High price impact can reduce the profitability of a trade, as the trader may end up paying a higher price to buy or receive a lower price to sell than they anticipated due to the market conditions. To minimize the price impact of their trades, traders may use various strategies such as splitting the trade into smaller orders, using limit orders, and trading on less volatile markets.

How to Minimize Price Impact

It is not possible to completely avoid price impact when trading cryptocurrencies, as any trade can potentially affect the market price to some extent. However, there are some strategies that traders can use to minimize the impact of their trades on the market price of a cryptocurrency:

1. Trade through pairs with high liquidity: Traders who buy and sell cryptocurrencies with low liquidity are more susceptible to moving the price against themselves.
2. Split large orders into smaller ones: Breaking down a large order into smaller orders can help avoid significant price movements and reduce the overall price impact.
3. Use limit orders: Limit orders allow traders to set the maximum price they are willing to pay for a buy order or the minimum price they are willing to receive for a sell order. This can help to avoid paying too much for a buy order or receiving too little for a sell order.
4. Use DEX Aggregators: Aggregators such as MatchaXYZ and CowSwap combine liquidity from many decentralized exchanges to reduce slippage and price impact.
5. Keep an eye on market depth: Market depth refers to the number of buy and sell orders at different price levels. Traders can use this information to estimate the potential impact of their trades on the market price.

What is Slippage?

Slippage in crypto refers to the difference between the expected price of a trade and the actual price at which the trade is executed. This can happen because of market volatility, order size, liquidity, and network congestion. 

When there is a lot of demand for a particular cryptocurrency and not enough supply, the price may move quickly, resulting in slippage. Slippage can also occur when a large trade is executed, causing the price to move in an unfavorable direction before the order is completed. 

In crypto trading, slippage can have a significant impact on the profitability of a trade, especially for high-frequency traders who rely on small price differences for profits. To minimize the risk of slippage, traders can use limit orders, which allow them to specify the maximum price they are willing to pay for a cryptocurrency.

How to Minimize Slippage

Minimizing slippage requires similar strategies to minimizing price impact:

1. Use limit orders: Limit orders allow traders to set the maximum price they are willing to pay for a buy order or the minimum price they are willing to receive for a sell order. By using limit orders, traders can ensure that their orders are executed at the specified price, or not at all.
2. Trade on more liquid markets: More liquid markets tend to have a greater supply of buyers and sellers, which can make it easier for traders to execute their trades at the desired price and reduce the risk of slippage.
3. Monitor market depth: Market depth refers to the number of buy and sell orders at different price levels. Traders can use this information to estimate the potential impact of their trades on the market price and adjust their order accordingly.
4. Avoid trading during periods of high volatility: During periods of high volatility, the market can move quickly, which can increase the risk of slippage. Traders may consider avoiding trading during these times or reducing their order size to minimize their risk.
5. Use DEX Aggregators