I was just wondering if someone could explain to me how an ETF market maker earns profit through the spread they collect while hedging the positions to be non-directional.
For example I read somewhere that: Say that ETF market maker buys ETF at bid and hedges that by shorting the basket. He then manages to offload that long position by selling at ask and flattening the hedge. From what I understand, the trader's profit = (spread earned) - (spread paid for hedge). Can someone confirm that this logic is correct? I was just wondering how this would be practical given that the basket might contain many other stocks and the trader would have to purchase all the underlying stocks of the ETF?
I was also wondering whether the creation and redemption mechanism has anything to do with the ETF market maker's operations. So back to the example above, instead of offloading the long position by selling to the trader. Is there a way to use the creation redemption mechanism to capture the bid/ask spread and to flatten the hedge? Perhaps he could redeem the ETF to obtain the underlying basket and flatten the hedge but how does he capture the bid/ask spread then?
I would appreciate if anyone could help me out with this! Thank you.