Hedging Basics for Market Makers
A market maker earns the spread. Any price risk they accumulate along the way is a byproduct, and it is uncompensated: nobody is paying you to be long. Hedging is how you remove it while staying in the market.
Separate compensated risk from uncompensated risk. You are paid for providing liquidity, not for directional exposure. Hedging keeps the first and removes the second.
Computing a hedge ratio
The hedge ratio is a regression slope. To hedge a stock position with index futures, regress the stock's returns on the index's:
Long $1m of a stock with , sell $1.2m of index futures to neutralise market exposure. What remains is the stock's idiosyncratic risk, which is smaller and which you may be willing to hold.
This is the regression material applied directly: a slope is a hedge ratio.
The three ways hedging goes wrong
Basis risk. The hedge is not perfect. Your instrument and the hedge move together usually, and the residual is basis risk. Hedging an obscure stock with an index leaves plenty of it; hedging with the same stock's future leaves almost none. The hedge that is cheapest and most liquid is rarely the one that matches best.
An unstable ratio. is estimated from history and does not stay put. A hedge computed in calm conditions is often wrong during a shock, and typically wrong in the unhelpful direction, since correlations tend toward 1 in stress and a hedge sized for normal conditions under-hedges precisely when it matters.
Over-hedging. Hedging away the risk you were paid to take. If you bought below fair value, that position has positive expected value, and hedging it perfectly locks in the spread but also removes the favourable drift you correctly identified. Over-hedging costs the spread on the hedge for no risk benefit.
Choosing an instrument
Ranked by how closely they match, and inversely by how cheap they are:
The same instrument. Perfect hedge, but if you could trade it you would simply unwind the position instead.
A future on the same underlying. Very close, highly liquid, cheap. The standard choice.
A correlated instrument. A sector ETF for a single stock, one commodity grade for another. More basis risk, sometimes the only option.
Options. Can hedge non-linear exposures that futures cannot touch, at the cost of introducing volatility exposure of their own.
Dynamic hedging
Market makers hedge continuously rather than per-trade, because each hedge costs a spread and hedging every fill would consume the entire edge.
The usual approach is a tolerance band: let inventory drift within some range, hedge when it leaves. Narrow bands mean tight risk control and high transaction costs; wide bands mean the reverse. Where the band sits is a genuine optimisation and one of the more consequential parameters on a desk.
For options books this becomes delta hedging, rebalanced as the underlying moves. Because delta changes with price (gamma), the rebalancing is continuous and its cost is a direct function of realised volatility, which is why an options market maker's P&L depends on how much the underlying actually moves rather than merely where it ends up.
Before hedging, ask what specific risk you are removing and whether you were being paid to hold it. A hedge that removes compensated risk is just an expensive way of not trading.