Definition
Flow Toxicity
Flow toxicity measures how informed and adverse the order flow hitting a liquidity provider is, with toxic flow being more likely to be followed by a price move against the provider.
Indian market-making algos estimate flow toxicity, often using volume-based measures of order imbalance, to decide when to widen spreads or step back from quoting. High toxicity signals that aggressive counterparties may be informed, raising the risk of adverse selection.
Monitoring toxicity helps liquidity providers avoid being systematically picked off during news or fast moves, and helps execution algos avoid trading into a one-sided, informed market. It is a practical microstructure tool linking order book imbalance, spread management and the timing of aggressive orders.
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.
- 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.
- 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.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.