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.

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3 Responses to “Adverse selection and uninformed traders”

  1. […] With spreads ever shrinking and a regulatory focus on transaction costs, dealers are rightly questioning all of the costs in executing in particular venues. The Liquidity Hub initiative will, just by having tough discussions with the existing platforms, help shape dealer/platform relationships going forward. Is there really any genuine reason a fixed income dealer should pay more in annual fees just to participate in a fixed income electronic venue as opposed to, say, an equity exchange? And why shouldn’t the dealer who is market-making get some of the value realised from their doing so? (check out etrading’s blog for an indication of why a market maker’s prices in an OTC market are of increasing value the further down the liquidity curve you go). […]

  2. […] Just had another one of those Harris moments reading in Harris on spreads. He points out that “markets that effectively enforce insider trading rules protect their liquidity suppliers from adverse selection.” Since adverse selection widens spreads, this benefits all traders relying on dealer supplied liquidity to execute their investment strategies. Posted in books, trading, reading harris | […]

  3. […] been heads down working on SpreadServe recently, so haven’t paid so much attention to the etrading topics that I used to blog about so much. Thanks to an update from mdavey, I’ve been catching […]

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