Backing out the spread from your return target

Question

You run a market-making book with \1 million of capital and a target return of 20\% per year, so \200{,}000 of annual profit. Your book round-trips about \500 million of notional volume per year. What average margin must you capture per round trip to hit the target? Express it in basis points and as a half-spread on a \100 stock.

Accepted Answer

Required margin = profit ÷ volume. Spread income is (margin per dollar traded) × (dollars traded), so: 	ext{margin} = \frac{\200{,}000}{\500{,}000{,}000} = 0.0004 = 0.04\% = 4 	ext{ basis points per round trip.} As a spread on a \100 stock. A 4-bp round-trip margin is 0.04\% 	imes \100 = \0.04 = 4 cents of full spread, which is a 2-cent half-spread (you earn half the spread on each of the two legs). Reading it. Notice how thin the required edge is. To make a 20\% return on capital, you don't need fat spreads, you need 4 basis points, over and over, on half a billion of turnover. This is th…

Backing out the spread from your return target

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