How Does the Risk of “Adverse Selection” Affect a Market Maker’s Quoted Spread?

Adverse selection is the risk that a market maker's quoted price is "stale" or incorrect, and they are trading with a counterparty (often an informed trader) who has better information. To compensate for this risk, market makers widen their bid-ask spread.

A wider spread increases the profit margin on each trade, acting as an insurance premium against being picked off by informed traders. Therefore, high perceived risk of adverse selection leads to wider spreads and higher potential slippage.