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I was wondering how Market Makers in ETF hedge themselves. I believe that they don't buy the underlying basket because some of the stocks could be extremely illiquid. So my guess is that they buy CALL/PUT options on the underlying index.

For example if you are long SPY, by PUT/CALL parity if you buy the PUT and short the CALL you are basically short SPY and thus you can hedge your long position this way. Is that how ETF market makers typically hedge themselves?

Yet my concerns are the following:

  • To hedge themselves using this strategy ETF market makers need also to be Options market makers no? Otherwise they will always loose the spread when buying the options by sending market orders. So they need to send limit orders to hedge themselves and maybe reduce the spread? so that they have more chance to hedge themselves quickly.

  • I've seen somewhere that sometimes they can use MultiLeg options to hedge themselves because it could be cheaper. Any clues of why? and what type of MultiLeg options they can be using?

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