Market Making with Cross-Asset Hedging and Spread Capture

Summary

The document explains how a market maker can earn a spread while managing inventory risk with a related futures contract. In its simplified example, a dealer quotes both sides of an illiquid S&P 500 ETF, buys shares from a seller, and shorts index futures to hedge the resulting long exposure. When a buyer later trades with the dealer, the ETF position is closed and the futures hedge is covered. The example calculates the gross ETF spread less the cost of the futures spread as the dealer’s profit.

It also notes that a market maker could leave inventory unhedged and seek to sell it later at a better price, accepting the risk that prices move adversely. The illustration assumes a sole liquidity provider, a particular ETF and futures price relationship, and successful execution on both sides. It omits fees, adverse selection, basis changes, financing, execution timing, and the possibility that the second customer never arrives, so it is a conceptual example rather than a complete profitability model.

Key ideas

• A market maker can earn the difference between its buy and sell quotes when both sides of a trade execute.
• A related futures contract can hedge the directional exposure created by an ETF trade.
• The example measures gross profit as the ETF spread earned less the futures spread paid.
• Holding inventory without a hedge may offer upside but leaves the dealer exposed to price moves.
• Realized results depend on execution, hedge basis, costs, and whether offsetting customer flow arrives.

Tags

# How do market makers make money


# How do market makers make money












I was looking into market making and the common idea is market makers make money by capturing the spread. I am a little confused about how this works, since on an exchange if the stock is listed that there are people ready to buy it for x and people ready to sell it for y, market makers have to buy from the exchange and sell it to the end user. According to NBBO , market makers cant charge more than y to sell and more than x to buy. Does anyone have any suggestions ?

## Answer by DataAdventurer (score 2, accepted)

https://quant.stackexchange.com/a/50709

Lets construct a simple example that shows a use case of Market Making.

Assumptions:

- You're are the only market maker for a very illiquid S&P 500 ETF

- S&P500 Level: 100

- S&P500 Futures Level: 99 / 101

- S&P ETF mid price: 100$

As the only Market Maker your job is to provide the market with liquidity. So you want to set sell and buy prices on the exchange. So what should you do?

To make money and provide liquidity your quotes (sell and buy prices) for the S&P500 ETF could be:

Sell / Buy

95 / 105

If someone want to sell 1 S&P ETF. He will be executed at your limit order @95. To hedge your risk exposure (you are long 1 ETF -> you lose money if the price drops) you short 1 S&P 500 Future @99. In the next hour another market participant comes around and want to buy 1 S&P ETF. You sell it to him @105 and cover your future short.

Whats the profit? Spread Earned - Spread Payed = (105-95)-(101-99) = 8$

Other examples could be taking the risk without a hedge and hope that you could sell your inventory higher as you bought it.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.