Adverse Selection
Market Microstructure glossary · Adverse Selection & Information Asymmetry
Definition
The risk that a counterparty has superior information. In microstructure, the risk that a dealer or limit order trader is trading with an informed trader who knows the true value better than they do.
Adverse Selection in plain English
Adverse selection is the danger of trading with someone who knows more than you do, so you win the harmless trades but lose the important ones. Imagine selling used phones at one fixed price: people who secretly know a phone is a dud walk away, while those who know it's a steal grab it, so the deals you actually close are quietly stacked against you. In markets, anyone posting a standing buy or sell price gets 'picked off' by better-informed traders right before the price moves their way. That hidden cost is a big reason posted prices carry a spread, part of which is insurance against getting picked off.
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