Delta hedging is an options trading strategy that aims to reduce, or hedge, the directional risk associated with price movements in the underlying asset. The approach uses buying & selling of the underlying asset or derivative to offset the risk to either a single other option holding or an entire portfolio of holdings. The investor tries to reach a delta neutral state and not have a directional bias on the hedge.
Without hedging, option sellers are exposed to significant movements in the price of an asset.
One of the drawbacks however is the necessity of constantly watching and adjusting positions in realtime as options are purchased. It also requires significant capital and incurs trading costs as delta hedges are added and removed to adjust the exposure.
In Optyn delta hedging is done at the protocol level for a liquidity swap pool.
Swap pool pairs are by design balanced in value 50/50 so they provide the starting and balanced state of the liquidity pool.
Over time purchases of either puts or calls the pool cause the pool to become exposed to significant price movements in a given direction.
The pool administrator has an administrative function that can liquidate a percentage of the liquidity in the swap pool and uses to the pool to purchase reserves in either the underlying or the hedge asset.
The benefits of doing this at the protocol level are:
Response time: Individual option sellers would need to respond quickly to hedge themselves if very large puts or calls come in with short time frames.
Aggregated trading costs: The trading costs for hedging are paid by the protocol once instead of every trader paying their own daily hedging trading costs
Capital requirements: A large notional option needs an equivalent size purchase/sale in the underlying asset. This requires capital over and above the capital required for collateralizing options.
The starting & balanced state weighted 50% value to each asset.
If the pool is exposed to 20% more call exposure than puts the pool administrator can mitigate the risk of a large price movement by selling 20% from the swap pool and converts it to the collateral. Storing it in the collateral reserves.
The administrative functions can either re-balance or weight it to one side or the other but nobody has direct access to the funds.
The function will be called by a protocol administrator to adjust the exposure of the pool. The functions don't provide any access to the funds to any individuals or company. The functions only direct the liquidity smart contract to add & remove its liquidity from the swap pool and buy/sell either the underlying or hedge and add it to its reserves.