How Market Makers Lose Money to Adverse Selection
Adverse Selection and Markouts
Market makers provide liquidity by quoting both bids and asks, earning the spread. But they face a structural disadvantage: informed traders can pick off stale quotes before the maker can adjust. This article explains adverse selection and how to measure it with markouts, using crypto derivatives as a concrete example. It covers inventory risk, hedging strategies, and the latency race between exchanges, showing why market making is a game of survival against better-informed flow.
Market makers can be viewed as having an inherent disadvantage in the market. This is because, unlike the takers in the market, the market maker must “show their hand” first by placing a quote.