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Suppose I am a market maker making a market on an S&P ETF. Suppose that I have calculated a fair ETF price of $395. My market therefore is 394.90 (bid) and 395.1 (ask). After my bid is posted I got filled with 10 shares of the ETF. Now I want to hedge this exposure.

Suppose that 1 outstanding ETF share consists of the following underlying shares {AAPL: 0.0123, MSFT: 0.0564, FB: 0.1434, etc. }. As far as I understand, market makers try to hedge the long ETF exposure by selling the underlying assets as much as possible. However, that would require me to 1) Sell short 500 different shares and 2) give me non-exact quantities such as 0.123 AAPL and 0.564 FB shares. In addition, it could be that shorting 1 AAPL share for instance would be a greater dollar exposure than the entire NAV of the ETF.

How would a market maker that got filled for 10 shares of the ETF go about it? Would they only hedge once a certain size of bids got filled (i.e. 1000 shares of the ETF)? Or for smaller quantities rely on the futures market?

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Market makers can and do try to make money by deciding how and when to buy / sell the underlyings, unless they are specifically prevented from having that agency by having some sort of stated algorithm for how / when it is done.

For example if they create and sell some ETF / basket shares to you in the morning, and the market is falling, they can wait until the afternoon to buy the underlying shares and still be net neutral by the close.

Exactly how hedging happens depends on who is doing the hedging, their stated objectives and applicable laws.

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In addition to @ThatDataGuy reply, that MM decide which positions and when to hedge, another point in ETF market making is the following:

For hedging positions on large baskets (as indexes) the best solution is not usually to hedge on all components, but to do some kind of analysis to see what are the main factors driving the performance of that particular basket. This does not mean hedging the largest positions on the index, but trying to decompose it into factors. For example, for hedging SPY, one possibility could be using a NASDAQ ETF plus some other smaller ETFs on industrial, services and banking companies, etc. assigning weights so that the performance of your hedging is as close as possible to the index in mind, and at the same time minimizing hedging costs.

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    $\begingroup$ Interesting response. What about using options to hedge? Could a market maker not simply sell ETF call options or buy ETF put options, so that in case that the underlying ETF shares decline they can offset some of the risk? $\endgroup$ Feb 12 at 17:22
  • $\begingroup$ Indeed, many MM may also use it, but note that options add extra risks to the problem, volatility being the most important. Moreover, many times business are organized in non-volatility/volatility desks, so this might not be the preferred choice. $\endgroup$
    – KT8
    Feb 13 at 6:54
  • $\begingroup$ Yes it's true that MM do some sort of factor analysis to decompose an indexes future performance into a smaller set of underlying stocks / constituents for lower trading cost. This is especially important for indexes / baskets which contain small holdings of lots of different securities, which can be illiquid. $\endgroup$ Feb 19 at 19:02

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