Adverse selection and flow toxicity

A flow is toxic for the liquidity provider when it is systematically informed: the takers are right just afterwards. Market makers measure this toxicity continuously, and their reaction (widening, pulling out) is a signal you can exploit too.

The toxicity indicators

• Persistent delta imbalance (or VPIN-type measures): the flow is directional and informed, the takers keep pushing the same way.
• Sudden spread widening: the MMs protect themselves, often before news or a bout of volatility.
• Massive liquidity withdrawal: nobody wants to provide. The book empties on both sides. A move is imminent, and it will be amplified by the absence of shock absorbers.
• Successive losing fills for passive orders: every executed limit is followed by a continuation against it.