What is slippage percentage in DeFi?

Slippage percentage refers to the difference between the expected price of a trade and the actual executed price. It is commonly used in decentralized exchanges (DEXs) to account for price volatility and ensure that trades are executed as closely as possible to the expected price.

When trading tokens on a DEX, the slippage percentage allows users to set a tolerance level for the price difference between the time they initiate the trade and when it is executed. Since token prices can change rapidly in volatile markets, the slippage percentage helps protect users from experiencing unfavorable trade execution prices.

Slippage is NOT equal to token tax.

For example, let's say you want to swap 1 PWR for a specific token. You check the current token price and set a slippage percentage of 1%. If the price of the token increases by more than 1% between the time you initiate the trade and when it is processed on the blockchain, the trade will fail to protect you from significant price difference. In this case, you would need to adjust the slippage percentage or re-evaluate your trade.

The slippage percentage accounts for various factors, including liquidity depth, order book imbalance, and market volatility. It ensures that traders are aware of and willing to accept a certain level of price difference when executing trades on DEXs.

Setting an appropriate slippage percentage is important to strike a balance between trade execution certainty and potential price impact. Higher slippage percentages provide more flexibility but may result in less precise trade execution, while lower percentages offer greater precision but increase the risk of failed trades or higher fees.

Here's a more detailed explanation of Slippage:

1. Token Swaps:

On DEXs like MaxxSwap, users can swap one token (e.g., wPWR) for another. When a user initiates a swap, they specify the amount of the token they wish to trade and the token they want to receive in return.

2. Market Liquidity:

The actual price at which the swap is executed depends on the liquidity available in the trading pool for the specific token pair. Liquidity refers to the amount of tokens available for trading in the pool. Tokens with higher liquidity tend to have lower slippage, while tokens with lower liquidity can result in more significant slippage.

3. Slippage Tolerance:

To protect users from unfavorable trades due to price volatility, DEXs typically allow users to set a slippage tolerance level. This represents the maximum acceptable difference between the expected and executed prices for the swap. If the slippage exceeds the user's specified tolerance, the transaction will fail, and the user will need to adjust the swap parameters.

4. High Slippage Scenario:

Slippage becomes more significant when there is lower liquidity for a specific token pair. If a user attempts to swap a large amount of wPWR for another token with limited liquidity, the trade may result in higher slippage. As a result, the user may receive fewer tokens than expected, and the cost of the trade may be higher than initially anticipated.

5. Slippage Calculation:

Slippage is typically expressed as a percentage. It is calculated by dividing the difference between the expected price and the executed price by the expected price and then multiplying by 100 to get the percentage. For example, if a user expected to swap wPWR at a price of 100 wPWR per million tokens but ended up receiving tokens at a price of 105 wPWR per million tokens, the slippage would be (105 - 100) / 100 = 5%.

Slippage is an important consideration for traders and liquidity providers on DEXs like MaxxSwap. To minimize slippage, users can choose trading pairs with higher liquidity or split larger trades into smaller transactions. Additionally, setting an appropriate slippage tolerance level can help users avoid unexpected costs due to price fluctuations during token swaps.

Simple Example of Slippage

Suppose Vue wants to perform a token swap using MaxxSwap on MaxxChain. He intends to exchange 100 wPWR tokens for another token, let's call it "Token X."

1. Before the Trade:

Before Vue initiates the trade, he checks the current price of Token X on MaxxSwap. The AMM's price for Token X is currently 5 wPWR per Token X.

2. Trade Initiation:

Vue initiates the token swap by specifying that he wants to exchange 100 wPWR tokens for Token X.

3. Slippage Impact:

Since AMMs operate based on a constant product formula (e.g., x * y = k), the price of Token X changes as the pool's token reserves are affected by the trade. If Vue's trade is relatively small compared to the liquidity pool's total size, the impact on the price of Token X may be minimal, and the slippage will be low.

4. Slippage Calculation:

Slippage is the difference between the expected price of Token X at the time of trade initiation and the actual price at the time the trade is executed. It is expressed as a percentage of the expected price.

For example, if the slippage is 1%, it means the actual price of Token X will be 1% higher than what Vue initially expected. If he expected to get 5 wPWR per Token X, the actual price might be 5.05 wPWR per Token X due to slippage.

5. Impact of Slippage:

Higher slippage can result from larger trades that significantly impact the token reserves in the liquidity pool. In such cases, the price of Token X may shift more than expected, leading to a less favorable exchange rate for Vue.

6. Minimizing Slippage:

To minimize slippage, traders like Vue can use smaller trade sizes or choose liquidity pools with higher reserves to ensure that their trades have less impact on the pool's token prices. Additionally, some DEX aggregators can optimize the trade execution across multiple AMMs to reduce slippage.

Common misconceptions of slippage

There are a few common misconceptions about slippage that can lead to misunderstandings or incorrect assumptions. Here are a few of them:

Slippage is the same as transaction fees: Slippage and transaction fees are two separate concepts in DeFi. Transaction fees are the charges imposed by the blockchain network for processing transactions, while slippage refers to the price difference between the expected and executed trade. Slippage is influenced by factors such as liquidity and market volatility, whereas transaction fees are determined by the blockchain network's fee structure.

2. Slippage is always negative: Slippage can be both positive and negative. Negative slippage occurs when the executed trade price is worse than the expected price, resulting in a loss for the trader. Positive slippage, on the other hand, happens when the executed trade price is better than expected, resulting in a gain for the trader. It's important to understand that slippage can work in favor of or against the trader depending on market conditions.

3. Slippage is avoidable: While traders can set a maximum slippage percentage when executing trades on DEXs, it does not guarantee zero slippage. Slippage is influenced by various factors, including liquidity depth, order book dynamics, and market volatility. In highly volatile or illiquid markets, slippage is more likely to occur, and it may be challenging to completely avoid it.

4. Slippage only affects large trades: Slippage can impact trades of any size, not just large ones. The impact of slippage is determined by the liquidity available in the market and the size of the trade relative to that liquidity. Even small trades can experience slippage if the market conditions are unfavorable or if there is insufficient liquidity to absorb the order without significant price impact.

5. Slippage is the exchange's fault: Slippage is a natural market phenomenon and not necessarily the fault of the exchange or DEX. It occurs due to the dynamics of supply and demand in the market. DEXs aim to provide the best execution possible given the prevailing market conditions, but slippage can still occur due to factors beyond their control.

6. Slippage Always Occurs: One common misconception is that slippage always occurs during token swaps. Slippage is not a mandatory outcome of every trade. It depends on the liquidity available in the trading pool and the size of the trade relative to the liquidity. If there is sufficient liquidity, slippage may be minimal or even non-existent.

7. Slippage is the Same for All Token Pairs: Slippage is specific to each token pair on a DEX. Different tokens may have varying levels of liquidity, and slippage can differ significantly between pairs. High-liquidity pairs may have low slippage, while low-liquidity pairs may experience higher slippage.

8. Slippage is a Fixed Value: Slippage is not a fixed value but rather a percentage difference between the expected price and the executed price of a trade. It is influenced by market conditions, liquidity, and the size of the trade.

9. Slippage is Always Detrimental: While high slippage can be undesirable for traders, it can also benefit liquidity providers. When there is significant slippage due to high demand for a token, liquidity providers can earn more trading fees, which can be advantageous for their participation in liquidity pools.

10. Slippage Cannot be Managed: Traders can take proactive steps to manage slippage. By adjusting their slippage tolerance or splitting larger trades into smaller ones, traders can reduce the potential impact of slippage.

11. Slippage is Unique to DEXs: While slippage is commonly associated with DEXs, it can also occur on centralized exchanges when trading low-liquidity assets. The concept of slippage exists in any trading environment where liquidity varies.

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