What Is ‘Adverse Selection’ and How Does It Relate to the Bid-Offer Spread, Separate from Inventory Risk?

Adverse selection is the risk that a market maker is trading with a party who possesses superior, non-public information (an informed trader). If an informed trader buys, the price is likely to rise, causing a loss for the market maker who sold at the ask.

The bid-offer spread includes an adverse selection component, which is a charge designed to compensate the market maker for this informational risk.