Adverse Selection Costs for Liquidity Providers

A markout compares a fill price to the market some time later, and a consistently negative markout is the cost of adverse selection.

Adverse selection cost is what a liquidity provider loses when its resting order gets filled by a counterparty who knows something about near-term price direction that the liquidity provider does not. The standard way to measure it is a markout, comparing the price at which a fill occurred to the market price some fixed interval later, and a resting order that consistently loses money on this comparison is being picked off by informed flow.

Suppose a market maker's resting bid is filled at 10.01, buying shares from a seller. Ten seconds later, the midpoint of the market has fallen to 9.98. The markout on that fill is negative three cents per share, because the price moved against the position the market maker was forced into by the trade. If this pattern repeats across many fills at that price and that interval, it signals the flow hitting that bid was informed rather than random.

The same calculation works in reverse for the offer side of the book. A market maker whose resting offer is lifted at 10.02, after which the midpoint rises to 10.05 over the following ten seconds, has also lost three cents per share on that fill, since the market moved up right after the market maker sold.

A positive markout means the opposite. If the price after the fill tends to move back in the market maker's favor, the flow trading against that quote was likely uninformed, or even mildly favorable to trade against, and the spread captured on the trade is closer to pure profit rather than compensation for information risk.

Desks typically compute markouts across several horizons, often something like one second, ten seconds, and five minutes after the fill, because different kinds of informed flow reveal themselves at different speeds. A fast, latency-sensitive signal shows up almost immediately in the short-horizon markout. A slower-moving signal, such as a large institutional order being worked over several minutes, shows up more clearly at the longer horizon.