The hedge that eats your spread

Question

You make markets in a stock, earning a 4-cent spread on your fills. But you don't want the directional risk, so you immediately hedge each fill by trading a related future, crossing its spread of 2 cents (a 1-cent half-spread each way, or 2 cents to get in and later out, assume 2 cents of hedging cost per round trip). What's your net edge per round trip? What if the future's spread were 5 cents instead?

Accepted Answer

Net the two spreads. You capture the stock's spread but pay away part of it hedging in the future: 	ext{net edge} = \underbrace{4	ext{ cents}}{	ext{stock spread earned}} - \underbrace{2	ext{ cents}}{	ext{hedge cost}} = 2 	ext{ cents per round trip.} You keep half of your headline spread. That 2-cent net is your true edge, the number that has to also cover adverse selection, carry, and fees before it's real profit. Why hedge at all if it costs half your spread? Because the unhedged risk is far larger than the hedge cost. If you sit on the stock position naked, you're exposed to the full …

The hedge that eats your spread

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