Why are small-cap spreads wider than large-cap spreads?

Question

A mega-cap stock quotes a one-cent spread all day, while a thinly traded small-cap in the same market quotes a spread tens of basis points wide.

Why are small-cap spreads structurally wider? Tie your explanation to the components of the spread.

Accepted Answer

Walk the three components; low liquidity elevates all three. 1. Inventory risk is high and hard to shed. With little volume, a market maker who takes on a small-cap position cannot quickly lay it off. The holding period is longer, the price can drift far before an offsetting trade arrives, and the hedging markets (or correlated names) are themselves thin. A larger, longer-held inventory risk means a bigger charge in the quote. 2. Adverse selection is worse. Fewer analysts and less public information cover a small-cap, so any given counterparty is more likely to know something the maker does n…

Why are small-cap spreads wider than large-cap spreads?

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