Whoever initiates a trade pays the spread for immediacy. The passive side earns it, but only on average, and only if the trades it receives are not systematically better informed than it is.
01Adverse selection
Adverse selection is the cost a liquidity provider bears when trading with someone who knows more about where price is going. If buyers tend to arrive just before price rises, the passive seller’s apparent gain from the spread is eroded or reversed by the move that follows. Liquidity providers respond by widening spreads and reducing size when they suspect flow is informed.
02Market impact
Market impact is the price change associated with a trade, and it has temporary and permanent parts. The temporary part reflects the liquidity consumed and tends to decay; the permanent part reflects the information the trade revealed. Separating the two requires observing how price behaves well after the trade, not only immediately.
A trade’s real cost is often measured after it is complete.
03Measuring the relationship
The link between aggressive execution and subsequent price movement can be studied by grouping trades by size, urgency or context and measuring price changes over fixed horizons afterwards. Impact that persists suggests information; impact that reverts suggests liquidity pressure. Each has different implications for how, and how quickly, a position is built.
Insights are research notes published for general information and education. They describe market mechanisms, not the firm’s positions or results. They are not investment advice or research recommendations, and nothing in them is an offer or solicitation.