Definition
Adverse Selection (Trading)
Adverse selection in trading is the risk that the counterparty filling your resting order knows something you don't, so liquidity providers are systematically picked off just before the price moves against them.
For an Indian market maker posting two-sided quotes, adverse selection means getting hit by informed flow, buying just before a fall or selling just before a rise. To compensate, market makers widen spreads, skew quotes and pull liquidity when toxicity rises, protecting against being run over by better-informed traders.
Adverse selection is a central concept in microstructure and explains why spreads widen in volatile or news-driven conditions. Managing it well is the difference between profitable and loss-making algorithmic market making, and it shapes how order book imbalance and flow toxicity are modelled.
Related terms
- Market Making (Algorithmic)Algorithmic market making is the automated, continuous posting of buy and sell quotes for a security to provide liquidity, earning the bid-ask spread while managing inventory and adverse-selection risk.
- Bid-Ask SpreadThe bid-ask spread is the difference between the highest price a buyer will pay (bid) and the lowest price a seller will accept (ask), representing a core implicit cost of trading and a measure of liquidity.
- Latency-Sensitive StrategyA latency-sensitive strategy is one whose profitability depends critically on speed of execution, such as market making and arbitrage, where being a few microseconds slower can mean missing the trade entirely.
- Order Book ImbalanceOrder book imbalance is the difference between resting buy and sell volume at or near the top of the book, used as a short-term signal of likely price direction.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.