Quick definition Adverse selection is the risk that a market maker incurs when they execute against a trader who has superior information or can access better prices. It is the core economic reason why bid-ask spreads exist. What it is A market maker quotes bid 100.00 and ask 100.10. A buyer hits the ask and buys 10,000 shares at 100.10. Seconds later, earnings are announced and the stock gaps to 105.00. The market maker has just been "adversely selected"—they sold to someone who knew material information. Adverse selection creates losses for market makers. To compensate for this risk, they widen their spreads. The spread is partly the cost of adverse selection risk. Why it matters Adverse selection is why market makers care about who they are trading with. Algorithmic traders that can predict short-term price moves create adverse selection risk. News traders create adverse selection risk. Informed traders create adverse selection risk. Market makers want to trade with retail traders (who lack information) and avoid trading with sophisticated traders (who have better information). This is impossible to do perfectly, so they compensate by widening spreads. Adverse selection versus inventory risk Market makers face two main risks: adverse selection and inventory risk. Inventory risk is the risk that they hold positions that move against them. Adverse selection is the risk that they trade with someone who is trading on superior information. These risks are distinct. A market maker might have no inventory risk (balanced long and short positions) but still face adverse selection risk (traded with an informed trader). Practical example A market maker in a thinly traded stock quotes 50.00 / 50.20. They know they face adverse selection risk—buyers might be buying on information they don't have. They widen the spread to 50.00 / 50.30 to compensate. A retail trader who sees bad news comes to market with a market sell order. The market maker buys 100,000 shares at 50.00. The bad news is public, so the market maker has not been adversely selected; they traded with someone without superior information. If an algorithmic trader had come to market with a buy order based on proprietary data predicting a price move, the market maker would face adverse selection risk. Estimation Market makers use statistical methods to estimate adverse selection costs. They track whether their trades are followed by immediate price moves against their position, which indicates adverse selection. High adverse selection costs force wider spreads. See also - Bid-Ask Spread - Market Maker - Inventory Risk - Information Asymmetry
