Delta Hedging and Delivery Risk Near Option Expiration
Summary
The document explains how option writers may manage exposure before expiration through delta hedging. In the simplified account, they hold a changing mix of the underlying stock and financing assets, adjusting that mix as the option’s sensitivity changes. The response says that near expiration an option is often sufficiently in or out of the money that the hedge is close to the exposure associated with the eventual delivery obligation.
It also notes that borrowing can finance a hedge and that offsetting customer positions may reduce the amount of exposure a dealer must hedge externally. These points offer a high-level account of risk management; they do not describe exercise rules, settlement mechanics, hedge slippage, or the risks of frequent rebalancing. The claim that the hedge has no risk is an idealization: delta hedging does not eliminate all sources of risk, and the response gives no quantitative evidence or detailed model.
Key ideas
- Option writers may use a changing stock and financing position to delta hedge their exposure.
- The response describes the hedge near expiration as close to the eventual delivery exposure when the option is far in or out of the money.
- Borrowing can fund an underlying hedge, while offsetting customer positions may reduce a dealer’s net exposure.
- The explanation is qualitative and does not detail settlement mechanics or residual hedging risks.
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Full text
# Do option traders actually have the underlying assets before maturity? # Do option traders actually have the underlying assets before maturity? The put and call short, long option graphs don't seem to reflect the fact that a short call or a long put position holder could purchase the assets before maturity especially if that price is below the strike price, and gain more through the difference between that price and the price at maturity. So is it always the case that the assets are automatically bought and sold at the maturity date(or maturity hour or maturity second)? But can it ever be perfectly simultaneous? What if there are price fluctuations between the time an asset is getting ready to be delivered and the actual moment of delivery? ## Answer by eSurfsnake (score 2) https://quant.stackexchange.com/a/39154 They usually delta hedge, meaning they hold the stock and bonds in relative amounts so that if the stock goes up 10 and that makes the option go up 3, they own 30% of the position in stock and 70% in bonds. They constantly adjust this hedge so they have "no" risk. By the time an option is about to expire, it is usually pretty far in or out of the money relative to "reasonable" short-term price moves. So what they hold is very close to what they must deliver (or not). What is hard to appreciate is if you buy an option on 1 million of stock, they can - and do -borrow 1 million at low intermarket bank rates and put on that hedge. And, if things go really well, they end up with customers with offsetting positions that hedge themselves, at least in part. There is a lot of detail but that is the basic idea.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.