Huang & Stoll (1997) decomposed the spread into three components: adverse selection (the risk of trading against someone who knows more), inventory holding (the risk of being stuck with a position), and order processing (the cost of doing business). Drag the slider below and watch all three shift in real time.
Spread Decomposition (Huang & Stoll)
- Adverse selection38%
- Inventory24%
- Processing39%
Active Market Makers
7 of 8 still quoting
- Spread
- 11.0 bps
- Regime
- Normal
- Makers quoting
- 7 of 8
- Adverse selection
- 38%
Notice how market makers withdraw as uncertainty rises. In crisis conditions, only one or two remain — and they demand a massive spread to compensate. A 2 bps average spread that was actually 0.5 bps for 48 seconds and 8 bps for 12 seconds tells a fundamentally different story than a steady 2 bps. The itself predicts future return volatility.
The model above is illustrative. Our has the spread on real markets, from one-minute bars up, with a free sample to try.