Confusion Regarding Dynamically Delta Hedging a Short Option

Question

To my understanding, market makers (mm) in the options market dynamically delta-hedge their portfolios by buying/shorting the underlying, thus eliminating directional risk and profiting from providing liquidity. For example, if a mm buys long a 0.5 delta call, they hedge by shorting (0.5 * spot) worth of the underlying. If the underlying moves up and the delta rises to 0.6, they adjust their hedge to be short 0.6 * spot, thus maintaining net-0 delta.

I'm confused about this delta-hedging when writing an option. Say a mm writes an ATM call that has a delta of 0.5. This makes them have a -0.5 delta on their position, and they hedge by buying 0.5 * spot. If the underlying rises by \$1, they are down \$0.5 on their option but gain \$0.5 from stock.

In the same scenario, though, let's say the underlying drops \$10, making the call OTM with a new delta of 0.4. The call is worth less than what the mm sold it for, so why would the mm need to readjust their delta hedge? Say they do readjust to long 0.4 * spot of stock, wouldn't this only expose them directionally? If the underlying drops again, they would lose money on their 'hedge', but can't profit more from the call they wrote than what they sold it for. Would the mm take their hedge off the table after criteria are met to avoid this?

I'm assuming I'm fundamentally misunderstanding something about writing options, delta, or how dealers delta hedge. Would greatly appreciate any insight. Sorry for the wordiness and thank you in advance.

Answer 1

You never know for sure what will be the next market move. You assuming that underlying will continue to decline and in this case additional hedge will eat your collected premium. But what if underlying will reverse? In this case you delta risk will eat you premiun even faster. You should always try to find right balance between frequency of hedging (which will help you collect delta moves from you underlying) and maximum delta expose (imagine that underlying will frequently move up and down, but you dont fix you profit). When you buy option you will have thetta appreciation, which you should compensate with fixing profit from each small moves of underlaying. When you write option you will collect premium, but you need to compensate delta risk with byys and sells of underlying but not much often - to not let comissions eat all you collected premium form writing option