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Your factor #1 above (about adverse selection through trading with a well-informed counterparty) reminded me of something I read in 'Trading and Exchanges'. Th
by rahimnathwani 6y ago
Your factor #1 above (about adverse selection through trading with a well-informed counterparty) reminded me of something I read in 'Trading and Exchanges'.
The section 'The Adverse Selection Spread Component' says that dealers will set their bid/ask spreads to account for the information they will get when someone hits their bid or whatever. So they need to estimate the probability that their next trade is with an informed counterparty.
If that probability is high, then they'll quote a higher spread.
Conversely, if they are quoting for retail order flow, they may assume they're never dealing with informed counterparties, and can offer a tighter spread.
- smabie 6y agoExactly! Being a market maker means constantly interacting with counterparties that have more information than you. In order to be successful you must utilize the core information they do not have: you are in the center of the order flow. Essentially, you must try to infer the knowledge that others possess by utilizing information about how they trade with you.