Definition of Price Impact in Cryptocurrency Trading
Price impact is the amount by which the price of a cryptocurrency will change as a result of a successfully completed buy or sell order.
In general, larger trades tend to have a bigger market impact, while smaller trades don’t affect princes as much.
Price impact refers to the correlation between an incoming order (to buy or to sell) and the subsequent price change.
Bouchaud, J. P. (2017, August 24)
However, the price impact of any given trade depends entirely on the liquidity of the market in which the trade was made.
Relationship Between Liquidity and Price Impact
Liquidity in crypto trading refers to the market’s capacity to absorb incoming buy and sell orders. Market participants, known as market makers, fill market orders and thus provide liquidity. They do this by placing limit orders at prices they deem fair and competing with each other to provide the best price on the market for market takers to take advantage of.
Liquid markets have a narrow bid-ask spread — the difference between the lowest price a seller is willing to sell for and the highest price a buyer is willing to buy for. On both sides of this spread, market makers are waiting for market takers to take their offer. When a market taker posts a market order, they are essentially accepting the best available offer for the asset. If they’re buying, they will purchase at the lowest available price.
However, if their order is sufficiently large, one market maker’s limit order may not be enough to fill it up. In that case, the automatic order matching system on the exchange continues to match what remains of the market order with subsequent offers from other market makers until it is completely filled. This pushes the price higher because market makers’ sell orders are ordered from the lowest price to the highest.
As each subsequent order gets filled up, the bid-ask spread is shifted up, and the price of the traded asset grows.
This is the relationship between liquidity and price impact.
Price Impact vs Price Slippage
Large price slippage most often happens in illiquid markets due to the relatively high price impact of individual trades.
Price slippage refers to the difference between the expected and the actual price at which a trade is executed. As mentioned, market takers create market orders, essentially asking to buy or sell an asset at the current best market price. Slippage is the change that the current market price experiences between the market taker creating the order and the order being filled up by the liquidity on offer by the market makers.
The price impact caused by one market taker posting a large market order right before another market taker will result in that second trader experiencing large slippage.
To summarize, price impact from relatively large traders results in slippage for traders.
Tools and Indicators to Measure Price Impact
To understand how big of an impact an individual trade will have on a market the best place to look is at the bid-ask spread and market depth.
Measuring Price Impact on a Centralized Exchange (CEX)
On traditional exchanges, this can be done on a depth chart — a trading chart specific to order book-based exchanges used to visualize market liquidity.
Depth charts visualize the volume available in limit orders on the market. The bigger that volume, the lower the price impact from individual trades. Traders will also experience less slippage.
Measuring Price Impact on a Decentralized Exchange (DEX)
Most decentralized exchanges (DEXs) use the Automated Market Maker (AMM) model instead of the order-book model to facilitate trading. On AMMs market making is done by algorithms instead of other traders. Traders exchange assets indirectly through a liquidity pool that holds both assets in a trading pair.
The algorithms in an AMM aim to keep both sides of the liquidity pool equal in value regardless of the amount of assets on each side. This equalization drives the prices of either side up or down relative to the other as assets are taken out or added into it.
The best way to see how big of an impact your trades will have is to look at the size of the liquidity pool. The bigger it is, the smaller your impact will be, and vice versa.
Most AMM-based DEXs also pre-calculate the price impact and show it to you when you are about to make a trade.
Conclusion
It’s important for traders, especially those trading in less liquid decentralized finance (DeFi) markets, to understand what is price impact in crypto, how it can affect their profits and influence slippage.
By leveraging tools and indicators to measure price impact, traders can develop more effective strategies to navigate the complexities of these markets and optimize their trading strategies.
Bouchaud, J. P. (2017, August 24). Price Impact. Capital Fund Management.
https://arxiv.org/pdf/0903.2428
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