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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

charm93
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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.

Magic is in the chain
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  • Does this mean then that the hedge funds and the banks generally don't want delta exposure? I would've thought hedge funds do use options to take directional bets on the underlying. – charm93 Jul 04 '19 at 07:21
  • Yes hedge funds come in many flavours indeed, and there is a whole host of strategies. The volatility strategies would be delta hedging the underlying as the vol is more important – Magic is in the chain Jul 04 '19 at 07:47
  • Right this makes sense. Just a few follow ups from me: are banks just trading vol now? And has this always been the case - or is vol trading just the flavour of the month currently? – charm93 Jul 04 '19 at 08:00
  • It varies by bank but they would desire to be market makers, matching buyers and sellers, than taking positions. It could be chaotic because market conditions have been challenging recently so the individual banks behaviour changes, at times drastically. – Magic is in the chain Jul 04 '19 at 11:40
  • hmm interesting – charm93 Jul 04 '19 at 13:22