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I noticed that E-mini S&P 500 futures (ES) typically trade with a very narrow bid-ask spread of 1 tick. What contributes to this small bid-ask spread? I can think of two reasons:

  • Lots of active market participants competing with each other, which encourages aggressive bids and asks.

  • The futures contract's underlying is approx. 500 stocks. Liquidity providers do not fear adverse selection by informed traders because traders are unlikely to have an information advantage on 500 stocks. Liquidity providers do not have to widen their spreads to compensate for adverse selection.

Am I correct? Did I miss anything?

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Lots of market participants - yes. It is the ultimate hedge and/or place to express your broad market views. While RTY may be a broader market index, in practice the 500 is probably a better proxy due to liquidity in the underlying names vs the lesser liquidity in the additional 1,500 names in RTY. Virtually every return benchmark is measured vs the market return, of which ES/SPX/SPY are proxies. When one wants to isolate or exclude systematic risk, ES/SPX/SPY is the place to go. Related, options market makers also may hedge their broad market delta exposure with ES/SPX/SPY. It should be noted that ES futures are realistically the best instrument to trade due to favorable, i.e. lesser margin requirements. The broad applicability of ES for various uses creates the demand and thus the increased liquidity.

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    $\begingroup$ This is a good answer (I upvoted), but would be a little better if @Bikenfly mentioned network effects. When contract becomes liquid and has narrow-ish spreads, it attracts more trading, garnering attention and even more liquidity, further lowering spreads. $\endgroup$
    – Brian B
    Oct 6, 2020 at 13:32
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"Did I miss anything?"

Size - TOB depth is historically low.

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  • $\begingroup$ I don't quite understand. How does small depth at the top of book cause these futures to have small bid-ask spreads? $\endgroup$
    – Flux
    Oct 5, 2020 at 13:04
  • $\begingroup$ To clarify my comment: 1) you're more likely to see a tight spread on small size; 2) bid/offer is not a complete picture of liquidity. $\endgroup$
    – user42108
    Oct 5, 2020 at 13:16

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