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

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