Market Making - Toxicity and Adverse Selection

Measuring and avoiding adverse selection

One of the largest, if not THE largest issue that market makers face is adverse selection.

You are providing quotes and there is some trader with more information about future price moves than you.
If he expects price to go up he will fill your quote on the ask side. Price then moves up causing him to make money and you to lose money.

In this article we will go over how you can measure the impact that those informed traders have on you and some ways to avoid toxic flow.

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Table of Content

1. Future Markout PnL

2. More Alphas

3. PIN

4. VPIN

5. Other measures of Toxicity

6. Final Remarks