Stardust9182 - no offence taken. I rarely get offended, and yes agree its an interesting discussion.
One thing I have learnt about a lot of these forums is that just because I/we/you may have a knowledge of something there is a lot of assumptions that others have a similar or at least partial knowledge as well. Hence the speaking Chinese while hearing Spanish. There is also different ways of looking at things, different cultures, experiences etc. (mind you some trolls are simply tools
)
I would define Delta hedging as a subset of offsetting. Offsetting is simply like reinsurance and spreading the risk. Delta hedging is one way to do it, from the perspective of a MM.
Key here is that if you have only ever trade single option strikes or strategies on one stock or instrument, you then have a different perspective to someone who may have traded a book in an instrument with multiple strikes and series, or even portfolio of options. The perspectives change and the focus changes.
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As for how someone may have hedged.....
example: (I dont know the specifics but will make up numbers)
Trader A sells Vix calls at 22 to Mktmakers (MM) for $1, the MM thinks they are theoretically worth** $1.10. They might hedge by selling the underlying, underlying drops, they lose $1 on the options, and make $2 as the vix falls or by buying and selling it, AND/OR also selling other options at different strikes or series at higher prices to their theoretical prices. Its a volume game.To them it might just be another trade in a series of trades.
(**Simply put: As a MM I viewed theoretical fair value is mainly only relative to other options at that point in time. Change the parameters or the supply and demand, the fair value probably changes, and over the long term, it should even itself out, but in the mean time there is a spread/edge to be made and its best done with similar objects if possible)
...or think about it this way.
The seller provided the MM with ammunition to be able to sell premium at other strikes and series to other people who wanted insurance. Thus they make money twice (theoretically)...,,,and if you keep doing this and somehow manage a balanced book then you fullfill your role as a MM - providing liquidity for those who wish to transfer risk.
To the Vix call seller, they might have been long options in multiple underlyings or the S&P. If there is an explosion of vix vol (volatility) one would assume it comes from individual vols going up.....
or they might be short the S&P, thinking that if it falls they make money here, lose in the Vix, but if the S&P sits still or rises slowly then selling the Vix makes money.
They might have been hedging against being long vol in other overseas markets.
They might have had other OTC option trades on.
These days with quant models what they are who knows!
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As I like to give live examples of real trades when I can.
TNT takeover Australia 1996. (Controvesial case as Simon Hannes was charged with insider trading. He allegedly bought calls and made money with an OTM 3 week till expiry opening purchase. )The MMs who sold them spread these against other calls, so while they might have lost on those individual calls, they made on their other call strikes as trading volumes went up, they also bought spreads with edges and if trading long gamma made money on the take over too. (unless they had too much long dated vol on), all without necessarily having directional bets on.
(Interestingly enough as I understand it the money was returned to the MMs from the alleged insider trading calls sold as no one claimed the money! It would have been an admission of guilt)
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apologies for the long post.
