Price Impact
Price impact refers to the change in an asset's market price caused by the execution of a trade on a decentralized exchange (DEX). Because prices on DEXs are determined by the ratio of tokens within liquidity pools, the size of a trade directly affects the asset's price.
Key Factors
The magnitude of price impact depends primarily on two factors:
- Trade size: Larger trades move the price more significantly.
- Liquidity depth: Deeper liquidity pools can absorb larger trades with less price movement.
How It Works
When a large trade occurs, it changes the balance of tokens in the pool. This adjustment causes the price to shift away from the current market price, increasing the cost (or reducing the value) for the trader.
Price impact is typically shown to users in transaction details before execution, helping traders understand how their orders might affect the execution price. In general, higher liquidity pools result in lower price impact, while smaller or less liquid pools experience more significant price movements from large trades.
Understanding price impact is crucial for traders to optimize trade sizes and avoid unnecessary losses due to market price shifts triggered by their own transactions.
