Arbitrage &
Market-Making

Jane Street is one of the world's largest ETF arbitrage traders, maintaining the pricing efficiency of ETF markets globally.

How ETF Arbitrage Works

• ETFs have a creation/redemption mechanism: Authorized Participants (APs) can create new ETF shares by delivering the underlying basket, or redeem ETF shares for the underlying basket.
• When ETF trades at a premium: APs buy the underlying, deliver to issuer, receive ETF shares, sell ETF. Premium collapses.
• When ETF trades at a discount: APs buy ETF, redeem for underlying, sell underlying. Discount collapses.

Jane Street's Role

• One of the largest APs globally across equity, bond, and commodity ETFs.
• Uses sophisticated models to identify mispricings in real-time across thousands of ETFs.
• Critical role during market stress: Provided liquidity during COVID crash, Flash Crash events.

Reference: https://www.etf.com/sections/features-and-news/jane-street-worlds-most-important-etf-trader

Statistical arbitrage (stat arb) exploits temporary mispricings between related securities.

Pairs Trading

• Identify two historically correlated securities (e.g., Coca-Cola and Pepsi).
• When the spread widens beyond its historical norm: short the overperformer, long the underperformer.
• Exit when the spread reverts to mean.

Factor-Based Stat Arb

• Long/short portfolios constructed from factor exposures.
• Common factors: Value, Momentum, Quality, Low Volatility, Size.
• Portfolio is market-neutral: zero beta to overall market.

Risks of Stat Arb

• Regime changes: Correlations break down during market stress.
• Factor crowding: Too many participants in the same trade.
• Convergence risk: Spread may widen further before reverting.

Resource: https://www.quantconnect.com/

Jane Street is a major options market maker, quoting bid/ask spreads across equity, index, and crypto options.

Options Market Making

• Delta hedging: Continuously hedge directional risk from options inventory.
• Vega management: Manage exposure to implied volatility changes.
• Gamma scalping: Profit from realized volatility exceeding implied volatility.

Volatility Arbitrage

• Trade implied volatility vs. realized volatility.
• Long gamma when implied vol < expected realized vol.
• Short gamma when implied vol > expected realized vol.

Key Greeks

• Delta: Directional exposure (hedged continuously).
• Gamma: Rate of delta change (determines hedging cost).
• Vega: Exposure to implied volatility changes.
• Theta: Time decay (premium seller earns daily).

Resource: https://www.sheldonnatenberg.com/

Beyond ETF arbitrage, Jane Street exploits pricing inefficiencies across venues and asset classes.

Cross-Exchange Arbitrage

• Same instrument trades at different prices on different exchanges.
• Speed advantage: Co-location at exchanges for sub-millisecond arbitrage.
• Example: BTC price difference between Binance and Coinbase.

Cross-Asset Arbitrage

• Index futures vs. index ETF vs. basket of stocks.
• ADR arbitrage: American Depositary Receipts vs. underlying foreign shares.
• Convertible bond arbitrage: Long convertible bond, short underlying equity.

Infrastructure Requirements

• Ultra-low-latency connectivity to all major exchanges.
• Real-time risk aggregation across venues.
• Smart order routing to best available price.

Reference: https://en.wikipedia.org/wiki/Arbitrage

Arbitrage is never risk-free in practice. Robust risk management is what separates successful arbitrageurs from those blown up.

Key Risks in Arbitrage

• Execution risk: Can't complete both legs simultaneously.
• Counterparty risk: Exchange or broker defaults.
• Model risk: Mispricing model is wrong.
• Liquidity risk: Can't exit position when needed.
• Correlation breakdown: Historically correlated assets diverge.

Risk Controls at Jane Street

• Gross and net position limits per strategy.
• Daily loss limits with automatic position flattening.
• Stress testing against historical crisis scenarios.
• Real-time risk monitoring across all books.

The famous quote: "Arbitrage is making money by doing nothing — until the day you lose everything."

Resource: https://www.risknet.org/