A Market Maker of Two Markets: The Role of Options in ETF Arbitrage

74 Pages Posted: 13 Sep 2023 Last revised: 29 Feb 2024

See all articles by Rabih Moussawi

Rabih Moussawi

Villanova University - Department of Finance; University of Pennsylvania

Lai Xu

Syracuse University

Zhaoque (Chosen) Zhou

Washington University in St. Louis - John M. Olin Business School

Date Written: July 1, 2022

Abstract

As major market makers provide liquidity in both ETF and options markets, this paper explores a new dimension of intraday ETF arbitrage using options. By focusing on the most liquid ETF, the S&P 500 ETF (SPY), and a proxy for a derivative hedge that is tied to the underlying basket, the S&P 500 index options (SPX), we examine how market makers perform intraday arbitrage following ETF order flow shocks. We examine the minute-by-minute liquidity and trading behavior in both the ETF and options markets using the ETF’s most buy and most sell minutes. We find that market makers are able to fulfill arbitrage trades by tapping into the liquidity provided by multi-leg complex options orders. Market makers provide price incentives to successfully establish hedged positions allowing them to capture the mispricing profits (annualized 35.79%) in addition to the bid-ask spreads in both security types. Overall, our study sheds new light on the interconnectedness between ETFs and derivatives markets in recent years.

Keywords: ETFs, Options, Intraday Arbitrage, Market Makers, Liquidity, Multi-Leg Options, Complex Order Book (COB)

JEL Classification: G12, G13, G14, G23

Suggested Citation

Moussawi, Rabih and Xu, Lai and Zhou, Zhaoque, A Market Maker of Two Markets: The Role of Options in ETF Arbitrage (July 1, 2022). Available at SSRN: https://ssrn.com/abstract=4395938 or http://dx.doi.org/10.2139/ssrn.4395938

Rabih Moussawi

Villanova University - Department of Finance ( email )

800 E Lancaster Ave
Bartley Hall, 2051
Villanova, PA 19085
United States

HOME PAGE: http://www.homepage.villanova.edu/rabih.moussawi

University of Pennsylvania ( email )

3733 Spruce Street
216 Vance Hall
Philadelphia, PA 19104-6301
United States

HOME PAGE: http://www.rabihmoussawi.com/

Lai Xu

Syracuse University ( email )

900 S. Crouse Avenue
Syracuse, NY 13244-2130
United States

Zhaoque Zhou (Contact Author)

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

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