Why Market Makers Sometimes Cross the Spread to Hedge

# Do market-makers often act as a taker (cross the spread) in other markets or assets while hedging?


# Do market-makers often act as a taker (cross the spread) in other markets or assets while hedging?












Do market makers often act as market-takers (cross the spread/market orders) in other markets or correlated assets while hedging?

## Answer by THATS MY QUANT MY QUANTITATIVE (score 4)

https://quant.stackexchange.com/a/81275

Short answer: Yes.

Long answer: Yes, but not always and it depends on a tonne of reasons like fee structure, spread, rebates, hedging requirements at the time etc etc.

Fundamentally, (ignoring rebates), if the spread on the derivative > spread paid during hedging, then they will sometimes cross spread with hedging. In the options market, the spread is larger than the underlying, therefore; by collecting the spread on the options with limit orders and adjusting their delta with market orders, the money they lose on the underlying will (hopefully) be less than the spread they gain on the option after they "flip" it.

But this is not always the case in the situation where a market-maker is in a long-gamma position. For example, if they hold only 1, 30D call contract in their portfolio and they short 30 stock (1 contract corresponds to 100 options), then they will be delta-neutral. When the stock rises, the delta of their contract could be like 32D, so their overall delta position is 2D. Therefore, they would short more stock to be delta-neutral again. But since the stock increased, had they placed a short limit order at approximately the distance of the gamma with units equal to the 2, their limit order would hit when their delta breached their tolerance. The same occurs for when the stock decreases and the delta of your option decreases. (This mechanic only works when your portfolio is net long gamma)

Continuing with this example, the market-maker will look at the collection of their positions as a system. So the Greeks can often "net-off" requiring less hedging, or no hedging at all.

But it gets complicated depending on the type of instruments they trade. For example, if they are an AP for an ETF, they will only be allowed to create or redeem the ETF at specific times. As a result, since it is often infeasible to hedge the ETF with ALL the underlying (the basket of stock), they will hedge the highest beta of the ETF. Additionally, if the ETF is multi-market, and has an out-of-hour corresponded i.e. futures market, they will look to hedge with correlated assets because their portfolio could get gapped on the overnight.

Regarding rebates: If an exchange is giving a MM friendly rebates, they may also require specific trading patterns and what they can and cannot do during market conditions.

Overall, it's complicated. A market-makers job is to find the cheapest and easiest way to get their limit orders filled whilst minimizing their risk. Sometimes that can be with market orders with hedging, sometimes it's not. And depending on how black-box their trading is, unique situations can occur and so traders sometimes try to figure out the best way to hedge their position on the fly.

## Answer by Mats Lind (score 2)

https://quant.stackexchange.com/a/81278

Yes, the market maker, MM, while delivering liquidity in off-runners, i.e. the less liquid instruments, from time to other takes liquidity (that's the market-taking in the question) in the most liquid instruments, the benchmark futures, to hedge.

MM will earn the bid/ask spread by serving liquidity to non-informed counterparties in the off-runners while paying (P/L losses) to informed counterparties. MM will take on an inventory of off-runners as a result from the trading. The inventory is risky but at least some of it is needed to serve potential buyers the next day. MM will reduce inventory risk by adding benchmark futures to the inventory, sometimes by taking liquidity in the benchmarks, and thus paying small cost for that liquidity.

And here is some math to go with that.

Hence, ideally for MM: low-information counterparties will take liquidity from MM by trading a lot of volume in a market with low volatility but high bid/ask spreads due to low competition from other MM. On top of that the market would ideally provide lots of liquidity sometimes to the MM in low bid/ask spread benchmarks.

To add some drama to it, in the most adverse situation, MM is hit several times by an informed counterparty thus sitting at end the day with both valuation losses and a large inventory for which there are no hedges available in the market. MM then only has the choice between carrying the inventory risk through the night in a terribly volatile situation or pay for liquidity selling the position against a large bid/ask spread.