Option Hedging Depends on Market-Maker Exposure and Net Risk

# Who hedges (more): options seller or options buyer?


# Who hedges (more): options seller or options buyer?












When the open interest increases, this means that there is a buyer and a seller of that option.

Both seller and buyer are behooved to hedge their positions, with the opposite sign; but I doubt that both hedge equally aggressively or systematically, with my guess being that it is the seller who hedges more often (because they know what they are doing in selling the option in the first place).

Are there any academic studies to (in)validate this?

## Answer by demully (score 10)

https://quant.stackexchange.com/a/61236

Your question comes at this correctly, in my opinion. There is indeed a buyer and a seller behind every option; but the hedging behaviour of the two need not be equivalent...

I used to work in an investment bank, and we used to call this (politely) "pin risk", or (less politely) "the gamma hammer".

The idea (not perfect, but close enough) being that the banks would hedge this more than their customers. So if the customers were net long of options (and thus gamma) while the banks were short, then any rise in spot would cause the customers' delta to rise, and the banks' to fall. The customers wanted that exposure; the banks have to hedge. The banks would have to buy a rising market (and vice versa), increasing volatility.

Conversely, if the banks' customers were net sellers of options/vol, then any rise in spot would cause the sellers' delta to fall, and the banks' delta would rise. So the banks would sell the underlying to hedge. They would sell into a rising market (and vice versa), suppressing volatility.

So what really matters here is not the intentions of the non-bank options trader, let alone their directional beliefs. It's their long-vs-short call-AND-put, the closeness of their strikes to spot, and the closeness of now to expiry, that matters. The customers don't hedge; the banks do. If they are longer of options/gamma than the banks, then the banks will increase vol... and vice versa. This will always work in the customers' favour; and against the banks' interests. Which is one reason why the banks charge a price for offering these kinds of exposures to customers... #justsaying ;-)

hope this is clear, DEM

## Answer by justasking (score 4)

https://quant.stackexchange.com/a/61294

It's not really a question of buyers vs. sellers, but of investors vs. market makers.

Market makers (market making firms, or banks - for whom this holds doubly due to regulation limiting their capacity to warehouse risk) are out to earn the bid-ask spread in exchange for providing liquidity, this means their goal is to fill your trade and exit the risk they take by being on the other side of your trade as quickly and cheaply as possible, this means they're big time hedgers both when they buy and when they sell.

N.B. that MMs will mostly hedge the net exposure of their whole book (as much of the flow will cancel itself out, e.g. buy and then sell the same contract) rather than hedge every transaction specifically.

## Answer by Mild_Thornberry (score 2)

https://quant.stackexchange.com/a/61234

You shouldn’t only consider the speculative investor. Insurers are a great example. They buy options to hedge risks they have already sold in terms of variable annuities and fixed index annuities, amongst others. Pension plans also can buy options to hedge risks they’ve already promised. In this case, the option is a hedge asset, not a speculative asset. The open interest will increase, and the option buyer will only appear to not hedge the asset. In reality, it is offset by the expected cash flows of their business. The ability to differentiate can never be know.

## Answer by nanoman (score 2)

https://quant.stackexchange.com/a/61241

Hedging is more essential for an option seller, because without hedging, their potential loss is unlimited (for a short call) or practically unlimited (for a short put). So, even if the trader is deliberately taking a delta or gamma position, some hedging is likely.

On the other hand, an option buyer may have no need to hedge if they are taking a directional position and are willing to risk 100% loss of premium. Of course, they would still hedge if they are a market maker or arbitrageur.

## Answer by nbbo2 (score 0)

https://quant.stackexchange.com/a/61296

In general I agree with the upvoted answers given above. But keep in mind that it is difficult to identify firms that are exclusive sellers of options, generally a market making firm has a complex (and ever changing) portfolio that includes both short and long positions. An "option seller" is an idealized construct that may not exist in real life. (Is Goldman Sachs a net option seller or an option buyer as of today, I don't know ;) ).