not able to understand delta in options. Whilst I understand, it is how much the option moves when the underlying moves by 1 unit, I fail to understand, when someone books a currency option, why does the delta need to be hedged.
closed as off-topic by LocalVolatility, Lliane, amdopt, skoestlmeier, Attack68 Mar 28 at 5:44
This question appears to be off-topic. The users who voted to close gave this specific reason:
- "Basic financial questions are off-topic as they are assumed to be common knowledge for those studying or working in the field of quantitative finance." – LocalVolatility, Lliane, amdopt, skoestlmeier, Attack68
It is true that when FX options are traded, the delta is often traded as well. That is a practice specific to the FX option market. It is called an "exchange of delta". You can undo it by selling the delta in the spot market immediately after the option trade. Or you can request no delta exchange at the time you make the trade.
Some say this practice arises to help option dealers hedge, some say it helps guarantee a fair price to the customer by making sure the dealer uses a valid spot price (see for example here https://fxtransparency.com/three-best-execution-strategies-for-vanilla-fx-options/). (Perhaps some FX option expert can tell us more about why this practice arose).
When you buy or sell an option you can choose what type of exposure you would like to have. In layman's terms, if you leave the Delta unhedged you are exposed to the price movements of the underlying. You would want that if you care about the direction of the underlying and have a view on whether prices go up or down based on whatever research you would have done to back up your claim.
In another case maybe you would like to have exposure only to the volatility of the underlying and you don't want any directional movements of the underlying to affect your option. Then you would hedge your Delta in the Market, to be Delta-Neutral, so directional exposure would be zero, then you would be only exposed to the other Greeks such as for example Vega, which is 1st order Greek, and stands for the volatility of the option. You would be speculating on certain events maybe that would cause prices to widely fluctuate without any particular direction. When you trade options you usually ask yourself, what is the price expectation of the underlying, what do I want to have exposure to in particular, which hedging options exist and how is the market positioned, what is the market mispricing. This is the most basic approach usually. If you believe the market should price the underlying higher or lower, you keep your delta exposure on the book. If you believe the price will fluctuate heavily you delta hedge and have a pure volatility play on your book because you believe that IV, Implied Volatility, is mispriced and the market is wrongly positioned based on the option smile for example. I tried to keep this explanation as basic as possible to ensure easy understanding. Hope it helps. The FX market has plenty of institutional participants such as Market Makers. Market Makers (MM), in general, do not care about directional movements in the underlying FX pair as their job is to price two-way prices, profiting from the bid/ask spread. Generally, MM's can keep the volatility exposure as that doesn't fall under the speculation regulation of directional positioning in the market, hence market makers, depending on the positioning of their book can profit from pure vega exposure, on the simple level of explanation. There is more than just vega regarding volatility, there is Vanna or Volga, but I leave it at just vega for the purpose of answering this question.
Delta does not have to be hedged. If you want to use options to make a directional bet, you dont want a delta hedge.
However, you dont need options to make a directional bet, that's what linear positions are for. What you can do with an option that you cant so with an outright position or linear derivative, is get an exposure to volatility.
Now if you have a position in an option, you have exposure to both volatility and directional changes. To take out the directional exposure, people delta hedge. A bit more precisely, when delta hedging, your profit or loss will depend on the difference between the implied volatility you bought or sold the option for and the realized volatility of the underlying. That PnL will realize through the option payoff, PnL on the delta hedge and interest on the cash