1. Properly explain the Bid-Ask Spread.
Just like in every market, the parties involved for trade are the buyers and sellers. In some cases, buyers are willing to pay for the underlying item or asset at the price quoted by the seller and sometimes too the buyer enters the market with a predetermined price usually different from the selling price. The price the buyer is willing to pay happens to be the highest price he is ready to pay and this is called the Bid price. The seller's quoted price is the minimum price the seller wants to sell the asset for, the Ask price. The Bid price and Ask price do not always agree and the difference is the Bid-Ask spread. Bid-Ask spread simply Spread is the difference between the buyer's price and the seller's price.
The difference between the Bid and Ask price (Spread) i.e. how small or huge the difference is also depends on how liquid the asset and market is. In a liquid market where there are enough sellers to meet the demands of buyers, trade is executed quickly and easily. In this case, buyers are ready to buy the asset at the selling price and this tends to make the Bid-Ask spread small because the difference in the bid price and ask price is relatively small.
Where the market is illiquid, the spread increases because buyers are not willing to buy the asset at the selling price. Once the difference in the prices increase, the volumes of trade reduces as compared to a liquid market case.
The simple formula for calculating the Bid-Ask spread= Ask price - Bid price.
2. Why is the Bid-Ask Spread important in a market?
Having identified what a spread is, how imporant is this information to market participants? Remember an asset with a relatively small or wide spread indicates how easy it is to trade the asset in the market.
An asset with a smaller spread indicates that the market is liquid i.e there are enough suppliers to meet demands making trade easy and quick whereas an asset with a wider spread indicates an illiquid market where there are low volumes of trade in the market.
In the nutshell, the bid-ask spread helps traders to identify how liquid the market (depending on how small or wide the spread is) and know when to enter the market. Moreover, it is prudent to execute your trade in a liquid market instead of an illiquid market.
3. If Crypto X has a bid price of $5 and an ask price of $5.20,
a.) Calculate the Bid-Ask spread.
b.) Calculate the Bid-Ask spread in percentage.
(a)
Bid price = $5 ; Ask price = $5.20
Bid-Ask spread (Spread) = Ask price - Bid price
= $5.20 - $5.00
Bid-Ask Spread = $0.20
(b)
Bid-Ask spread percentage = (Spread/Ask price)*100
Spread = $0.20 ; Ask price = $5.20
Bid - Ask spread percentage = (0.20 / 5.20)*100
= (0.03846)*100
= 3.846%
Bid - Ask spread percentage = 3.85%
4. If Crypto Y has a bid price of $8.40 and an ask price of $8.80,
a.) Calculate the Bid-Ask spread.
b.) Calculate the Bid-Ask spread in percentage.
(a)
Bid price = $8.40 ; Ask price = $8.80
Bid-Ask spread (Spread) = Ask price - Bid price
$8.80 - $8.40
Bid-Ask Spread = $0.40
(b)
Bid-Ask spread percentage = (Spread/Ask price)*100
Spread = $0.40 ; Ask price = $8.80
Bid - Ask spread percentage = (0.40 / 8.80)*100
= (0.04545)*100
= 4.545%
Bid - Ask spread percentage = 4.55%
5. In one statement, which of the assets above has the higher liquidity and why?
With the understanding that assets with smaller spreads are highly liquid than those with wider spreads, it is evident that Crypto X with a spread of $0.20 has a higher liquidity than Crypto Y with a spread of $0.455 comparing the two.
6. Explain Slippage.
We say there is a slippage when a market order is executed at a price different from what the trader saw at the time of placing the order. A slippage can either be a plus on price or a minus. The high volatiliy nature of crypto assets is a major cause of slippages where the price of crypto assets can make significant movements within a short period for instance from the time the order is placed and when the order is executed which then causes slippage. Slippage is likely to occur in an illiquid market where the bid-ask spread is wide because it usually takes a longer period for the order to execute hence changing the price at the end of the trade.
7. Explain Positive Slippage and Negative slippage with price illustrations for each.
Positive Slippage
A slippage is positive when it favors the trader's position. When a trader takes a long psoition or places a buy order, when the order is executed at a reduced price than he intended to buy the asset it is a positive slippage same way when a sell order is placed but the order was executed after the price went up.
Illustration
Duke places a buy order for Crypto A when the price was $40. The order didn't execute immediately perhaps because of illiquidity in the market. Later in the day, a check on the trade revealed that the trade was executed but at a reduced price of $37. This is a positive slippage of $3 because the asset has been bought at a further reduced price.
Duke again placed a sell order for Crypto B when the price was $70. The order executed at $72 instead. This is a postive slippage of $2 because the aset was sold at a higher price than Duke intended to sell it.
Negative Slippage
This is the direct opposite of Positive slippage. Here the slipage does not favor the trader. When a trader places a buy order and the order executed at a price that is above the intended buyng price it is a negative slippage. A sell order executed at a price lower than the intended price of the trader is also a negative slippage because the trader then sells the asset at a lower price than he intended.
Illustration
Duke places a buy order for Crypto A when the price was $40. The order didn't execute immediately perhaps because of illiquidity in the market. Later in the day, a check on the trade revealed that the trade was executed but at an increased price of $41. This is a negative slippage of $1 because the asset has been bought at a higher price than Duke intended.
Duke again placed a sell order for Crypto B when the price was $70. The order executed at $66 instead. This is a negative slippage of $4 because the aset was sold at a lower price than Duke intended to sell it.
Conclusion
The Bid-Ask spread is an important tool traders pay attention to as they indicate how liquid the market is and it is prudent to trade in high liquid markets. Liquid markets have smaller spreads whereas Illiquid market have wider spreads.
Due to the volatility in cryptocurrency prices, there is a likelihood for slippages where the price the order was executed differs from the intended price. Slippages can either be positive or negative.
Thanks for reading. Kudos to @awesononso for this informative lecture. I will be ready to take on the next.