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Using Futures to Hedge ETF Market Maker Inventory

Article Quant Q&A · Author: Leopardl
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Summary

The document considers how a market maker might hedge ETF inventory after trading with a large investor. In one case, the market maker buys ETF shares and is left long while arranging to sell them over time; in the other, the market maker sells shares to a buyer and may need to hedge the resulting exposure. The question initially suggests using options to offset directional delta in the long position.

The response identifies futures as a common hedge that can be used on either side of the trade. This provides a simple directional framework: a market maker can take a futures position opposite the inventory exposure while working the ETF order. No contract selection, hedge ratio, basis adjustment, execution schedule, or numerical example is supplied. The advice therefore gives a starting concept, but does not explain how to manage tracking differences, changing exposure, or costs in a particular ETF market.

Key ideas

  • Futures are proposed as a way to hedge ETF inventory on either side of a market-making trade.
  • A long ETF inventory position creates directional exposure while shares are being offloaded.
  • The original question considers options as a possible delta hedge for a long position.
  • The response gives no hedge ratio, contract specification, or discussion of basis and execution risk.

Tags

Market makingFuturesExecutionMarket microstructure
Full text
# Market Maker ETF Hedging Strategy


# Market Maker ETF Hedging Strategy












Some thoughts about ETF hedging; feel free to leave comments!

Scenario 1:

An investor sells 1M ETF shares to a Market Maker(MM) at bid price. MM has a long position and will need to offload the shares bit by bit. How does MM hedge its position prior to the long position? My guess will be using option - MM has a positive delta and therefore needs a put option to bring down the +ve delta.

Scenario 2:

An investor wants to buy 1M ETF shares from MM. Is there any hedging strategy involved in this case? If so how?

## Answer by Bob Jansen (score 1, accepted)

https://quant.stackexchange.com/a/46727

One popular strategy and the one that works very well if it can be done is hedging using futures. This can be done on both sides.

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.