Build your spread from the ground up

Question

You make markets in a stock worth 20.00. From your fill data you estimate that adverse selection costs you about \0.03 per fill on average (informed flow moving value against you). On top of covering that, you want a 2-cent profit margin per fill. What is the minimum spread you can post? What happens if a competitor quotes tighter than your adverse-selection cost?

Accepted Answer

Stack the components. Your half-spread has to cover the cost of getting picked off and leave the margin you want: 	ext{half-spread} = \underbrace{c}{	ext{adverse selection}} + \underbrace{m}{	ext{margin}} = 0.03 + 0.02 = 0.05. So you quote a 5-cent half-spread, a 10-cent full spread, centered on fair value: 	extbf{19.95 bid / 20.05 ask.} Anatomy of the spread. Every fill collects 5 cents. On average 3 cents of that is eaten by adverse selection, leaving 2 cents of real profit. If you quoted only a 3-cent half-spread (19.97/20.03), you'd exactly break even, collecting just enough to offset…

Build your spread from the ground up

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