What Is the Concept of 'Adverse Selection' in Market Making and Slippage? ▴ Learn

What Is the Concept of ‘Adverse Selection’ in Market Making and Slippage?

Adverse selection is the risk that a market maker trades with an informed party who possesses superior information, leading the market maker to lose money on the trade. This happens when the market maker's quoted price is "stale" and the informed trader knows the price is about to move.

To compensate for this risk, market makers widen their bid-ask spreads, which increases the transaction cost and potential slippage for all market participants.

Why Do Out-of-the-Money Options Often Have Wider Spreads?

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

How Does a Market maker’S’inventory Risk’ Directly Cause the Bid-Offer Spread to Widen during High Volatility?

How Does the Presence of ‘Informed Traders’ Impact the Market Maker’s Quoting Strategy beyond Simply Widening the Spread?