Order Flow Toxicity
Market Microstructure glossary · Adverse Selection & Information Asymmetry
Definition
A measure of how adverse-selection-laden incoming order flow is to liquidity providers; high toxicity precedes widening spreads and market-maker withdrawal.
Order Flow Toxicity in plain English
Market makers are firms that constantly offer to buy and sell a stock, earning a small margin. Their nightmare is trading against someone who KNOWS something they don't — like selling a stock cheaply to a person who's certain it's about to jump. 'Order flow toxicity' measures how likely the incoming orders are to be from these dangerous, better-informed traders. When toxicity spikes, market makers widen their prices to protect themselves or step away entirely — which is exactly why a burst of toxic flow often comes right before spreads blow out and liquidity dries up. It's the market maker's version of a shark-in-the-water warning.
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