Every cost that a spread has to pay for

Question

You make markets in a \40 stock and want to know the smallest full spread you can post without losing money. Your measured per-fill costs are: - Adverse selection: \0.025 per share (informed flow moving value against you). - Inventory carry: you hold a fill about half a day on average; financing plus expected mark-to-market drift costs \0.010 per share. - Processing / fees: exchange and clearing costs net \0.005 per share. What minimum spread breaks you even? What must you charge to earn a 1-cent-per-share margin?

Accepted Answer

Add the per-fill costs. Each fill must at least recover everything it costs you: c{	ext{total}} = \underbrace{0.025}{	ext{adverse}} + \underbrace{0.010}{	ext{carry}} + \underbrace{0.005}{	ext{fees}} = 0.040 	ext{ per share.} That \0.040 is what a single fill costs. But a market maker earns the half-spread per fill (you collect the distance from mid to your quote each time someone trades against you). So break-even requires 	frac{	ext{spread}}{2} \ge c{	ext{total}} \;\Longrightarrow\; 	ext{spread} \ge 2 	imes 0.040 = 0.080. Minimum viable spread: 8 cents, quote 39.96 / 40.04 around a…

Every cost that a spread has to pay for

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