Why Options Traders Delta Hedge Deep Out-of-the-Money Options

Summary

The answer explains that participants may buy options to gain exposure to volatility rather than to the underlying asset. In that case, a fund may hedge the option’s delta to reduce directional exposure. Option dealing desks focused on volatility may hedge delta for the same reason, creating a natural alignment between buyers and sellers.

The hedge must be adjusted as the option’s delta changes, though participants may choose to hedge only exposure they consider material. The answer also suggests that dealing with a counterparty already hedging delta can offer better terms than arranging a separate hedge. This is a general explanation, framed around foreign exchange markets; it does not quantify costs or discuss how hedge size should be chosen for a particular portfolio.

Key ideas

• A trader may buy an option to obtain volatility exposure while limiting exposure to the underlying asset.
• Volatility-focused dealing desks may also delta hedge their option positions.
• Both sides’ interest in avoiding underlying exposure can support a natural match.
• Delta hedges may need updating as the option’s delta changes.
• Some participants may hedge only material exposure, depending on their broader positions.

Tags

# Why does it make sense to delta hedge a deep OTM option given the very low delta exposure?


# Why does it make sense to delta hedge a deep OTM option given the very low delta exposure?












I am not sure if this is actually done in practice as I'm not a derivatives trader, but I can only think of reducing the cost of the OTM option as a reason for delta hedging a deep OTM option, which is likely to be pricey/expensive.

Appreciate the help on this

## Answer by Magic is in the chain (score 1, accepted)

https://quant.stackexchange.com/a/46433

It really depends on the participant, but generally speaking, say in the FX markets, hedge funds would buy options to get exposure to volatility, not the underlying, so they delta hedge the option. The banks desks dealing the options don’t want exposure to the underlying either as these would be volatility desks whose expertise is vol so they would delta hedge as well. Hence there is an automatic match, and you will get better terms than if you were to hedge delta with a new counterparty or as a new trade.

The delta hedge will be updated as the option delta changes but you will have to start somewhere, though possibly many participants would have a strategy to hedge only material exposure. but then you won’t own just one option.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.