What are practical examples of adverse selection market makers have to deal with?? I’ve read books but couldn’t really understand the concepts…
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$\begingroup$ The risk is that the counterparty knows something that the market-maker does not yet know and is not reflected in the price (in the literature this is called an informed trader as opposed to a liquidity or noise trader). So he/she knows some news that is not yet well disseminated (it could be insider trading (illegal) but could also be someone who is at a press conference and getting information directly from the company, etc.). $\endgroup$– nbbo2Commented Feb 15, 2022 at 17:30
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$\begingroup$ Thanks, how could that affect the price? And what market makers do to mitigate the effect? $\endgroup$– KmdCommented Feb 15, 2022 at 17:33
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$\begingroup$ The mkt maker loses when he sells to an informed buyer or buys from an informed seller, he regrets the trade once the info becomes public.. The theoretical models say the greater the probability of adverse selection, the greater should be the bid-ask spread the market maker uses. A wide ba spread will compensate for some adverse selection the theoreticians say. $\endgroup$– nbbo2Commented Feb 15, 2022 at 17:36
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$\begingroup$ Can the market maker price arbitrarily? Don’t they simply price based on NBBO? $\endgroup$– KmdCommented Feb 15, 2022 at 17:55
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$\begingroup$ @Kmd Generally, market participants can show whatever prices/quantities that they desire unless there is some pre-existing agreement with an exchange as is the case for many LMMs. Although, typically any MM would at least consider the NBBO in pricing. Let's say that stock ABC is 99@101 and you think that the price should actually be 150. Perhaps you may try to show bids for 100 so you will be the best bid and can slowly accumulate a long position as any sales will go to you. Or maybe you think this opportunity is going to disappear and you would just buy as much as you can for 101. $\endgroup$– Evan SemetCommented Aug 2 at 22:50
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3 Answers
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One way to intuit this is in terms of future (markout) PnL:
- Place a bunch of limit orders randomly at BBO.
- Get filled on them.
- Measure their average markout PnL in terms of future midprice move.
- Observe that the PnL is negative, i.e. price moves against you after the average fill.
This move against you is one way you can quantify the adverse selection on a market maker (limit orders).
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adverse selection is something very easy to understand. A market maker should quote both on buy and sell side. When a bid order is executed, market maker wants the price to go up which makes the ask order executed as well, then he can make the money of spread. But once the price goes down, he's undertaking the float loss. To deal with it, market makers always build a model to predict the price movement, if the signal shows the price will go down, the bid order will be canceled to avoid loss.
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Adverse selection is a result of information asymmetry in the market.
Not every market participant has equal access to information/research capabilities. In other words, some firms/individuals know more than others.
Your question more so pertained to actual examples of this, so I'll just list off a few:
- Insider trading
- Market manipulation tactics (banging the close, etc.)
- Firms that have more direct access to flow information
