Price Impact and Slippage

What is Price Impact?

Price impact refers to how much the price of an asset moves due to a trader’s order consuming liquidity at various price levels in the order book.

Mechanism

  • An orderbook consists of limit orders at various prices. The best available price for a buyer is the lowest ask, and for a seller, it’s the highest bid.
  • When you place a market order, it consumes liquidity starting from the best available price and moves deeper into the order book as necessary to fulfill the order.
  • The larger the market order, the more price levels it will sweep, leading to a greater price impact.

What is Slippage?

Slippage is the deviation between the expected price of a trade (based on the top of the orderbook) and the actual average price at which the trade is executed.

Mechanism

  • Slippage occurs due to price impact (trading across multiple price levels in the book) and/or market conditions like volatility.
  • The key factors affecting slippage are:
    1. Order Size: Larger orders consume more of the orderbook, resulting in more slippage.
    2. Market Liquidity: Thin orderbooks with low volume at each price level exacerbate slippage.
    3. Volatility: Rapid price changes during execution can lead to unexpected outcomes.
Price LevelAsk PriceAsk Size
1100,00010
2100,0105
3100,03010

If I submit a market order of size 20, I will get the following fills :

  • 10 at a price of 100,000
  • 5 at a price of 100,010
  • 5 at a price of 100,030

The price impact in this case was $30.

The average fill price is :

(100,000 * 10 + 100,010 * 5 + 100,030 * 5) / 20 = 100,010

So the slippage relative to best ask price was $10

How can I minimize my slippage?

  • Limit Orders:
    • Place limit orders at desired prices to avoid price impact and control slippage.
    • Note: This risks the order not being filled if the market doesn’t reach your limit price.
  • Order Splitting:
    • Break large orders into smaller chunks and execute them over time to reduce price impact.
    • TWAP (Time-Weighted Average Price) can help to do this in an automated way
  • Use Market Depth:
    • Analyze the orderbook depth to estimate how much liquidity is available at each price level before placing large orders.
  • Set Maximum Slippage :
    • Define a maximum acceptable slippage to avoid orders executing at unexpectedly poor prices.
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