Trade Size and the Adverse Selection Component of the Spread: Which Trades are "Big"?

Existing research suggests adverse selection spread components are positively related to trade size, consistent with informed traders trading in larger sizes. However, if market makers use quoted depth to limit losses to informed traders, the size of a trade relative to the depth quoted at the time of the trade is potentially a better indicator of informed trading than is trade size alone. We show that much of the variation in adverse selection estimates can be explained by variation in the ratio of trade size to depth. Further, the previously documented relation between adverse selection spread component estimates and raw trade size largely disappears when the ratio of trade size relative to depth is held constant. Finally, we find that the previously documented intraday pattern in adverse selection estimates does not exist for trade sizes that approach or exceed the quoted depth. That is, for large (relative to depth) trades, the time of day at which a trade occurs provides virtually no incremental information about the probability the trade is informed. In sum, our results indicate whether a trade is 'large', and therefore indicative of informed trading, depends on the depth in effect when the trade occurs.