Adverse selection and uninformed traders
August 31, 2006
Harris bills section 14.3 of Trading & Exchanges, on adverse selection and uninformed traders, as the most important lesson in the book. Trading authors often comment that novice traders get ground down by transaction costs. We all know that trading is a zero sum game. Harris explains exactly how trading by dealers and informed speculators grinds down the rest in that zero sum game. “Informed” means informed on fundamental values.
So what is adverse selection ? Dealers quote buy and sell prices for all instruments they deal. Adverse selection is the risk that a better informed trader will take one of a dealers prices and leave them with a position against which the market subsequently moves, making it difficult to unwind that position. If a dealer thinks they’ve just traded with a better informed trader, they can take several steps in mitigation: they can change quoted prices and sizes to discourage further trades on the same side, and encourage trades on the other side. Or they can unwind an unwanted position immediately by paying for liquidity and taking someone else’s prices. Or they can hedge eg buy the future if they just sold the bond.
Uninformed traders don’t get ground down because they always pick the wrong side of the market: buying before a drop or selling before a rally. They lose because dealers build the cost of adverse selection into their spreads, among other reasons. So the zero sum game means that dealers charge uninformed traders for their losses to informed traders. Of course, dealers can and should be well informed traders themselves, even if they do encounter better informed traders in the market.