Why do spreads widen right before an earnings release?

Question

A stock trades a penny wide all afternoon. Ten minutes before its scheduled earnings release, every market maker pulls back and the quote balloons to twenty cents wide.

Which of the spread's three cost components is spiking, and why does the timing make it worse?

Accepted Answer

Recall the spread covers three costs: adverse selection, inventory risk, and order processing. Order processing (fees, technology) has not changed at all in these ten minutes, so it is not the story. Both of the other two rise, but the dominant driver is adverse selection, sharpened by the fact that the news is scheduled. Adverse selection spikes. Right before a known event, the population of people trying to trade shifts toward those who think they know something: traders positioning on a leaked number, on a strong read of guidance, or simply on a sharper model of the surprise. If you leave …

Why do spreads widen right before an earnings release?

Your answer

More Market Making questions