Why uncertainty about fair value belongs in your spread

Question

You're asked to make two-way markets on two things, both of which you think are worth about $50$ :

Asset A: a liquid ETF you price to the penny; you're confident fair value is $50.00 \pm 0.02$ .
Asset B: a thinly-traded name you barely follow; your honest estimate is $50 \pm 5$ .

Should you quote them the same width? Put rough numbers on each and explain the principle.

Accepted Answer

No, width should scale with your uncertainty about fair value. Quote A tight and B wide: 	ext{A: } 49.98 \,/\, 50.02 \quad (	ext{4-cent spread}), \qquad 	ext{B: } 47 \,/\, 53 \quad (	ext{6-point spread}). Why the wide market on B is not cowardice but arithmetic. Your quote is a standing offer to trade at a price. If your fair-value estimate could be off by \5, then a 4-cent-wide market on B is a gift to anyone who knows B better than you: whenever the true value is, say, 53, they lift your 50.02 offer and you've sold something worth 53 for 50, a \3 loss. Tight quotes only make sense when …

Why uncertainty about fair value belongs in your spread

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