What Is Adverse Selection?

Market makers face a problem called adverse selection.

Suppose a market maker provides a quote to buy or sell an instrument.

Another participant trades against that quote just before the market moves against the market maker's position.

The market maker may then be left holding inventory at an unfavorable price.

This risk is one reason market makers continuously adjust quotes and manage inventory.

Providing liquidity isn't risk-free, even when a participant earns the bid-ask spread on many transactions.

For order flow traders, the lesson is that displayed liquidity reflects a changing decision process.

Orders can be modified or withdrawn as market conditions change. A large resting order should never be treated as an unconditional promise to defend a particular price.