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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?

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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

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It's not just a question of buyers vs. sellers, but also 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.

EDIT: 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.

Beyond this, I think the answer is likely to be sellers, because their unhedged downside risk is not capped in the same way as it is for someone who is long an option and can only lose the premium they've paid at worst (though there are reasons for non-MM buyers to hedge too.)

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  • $\begingroup$ I hear you; but you are making a big assumption that the seller doesn’t already own the security they’re short vol of. Selling a covered call is vol-reducing if you own the stock, so the writer is maybe less likely to trade than someone owning the stock without the hedge. Likewise a put-seller with cash versus a speculative put=buyer without stock ownership, given put-call parity, you cannot infer anything about any option position without knowing about their position in the underlying, which you cannot know. Sorry.... $\endgroup$ – demully Feb 22 at 1:00
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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.

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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.

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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 ;) ).

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    $\begingroup$ Yes, precisely so. The issue is not what GS-et-al decide to do; but what their customers d3cide to do. GS-et-al are naturally on the other side of this bayside flow; but their hedging behaviour is different to their clients. So the sellside hedging (that does move markets) does vary, according to the bias and aggression of buy-side behaviour at any point in time $\endgroup$ – demully Feb 22 at 0:51

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