I follow a Twitter account that posts what big trades occured in the SPX pit. I understand that the market makers/traders in the SPX pit hedge their positions by taken positions in the E-Mini S&P Futures contract (ES). Are all they doing is hedging their delta? Let's say for example, a Market Maker needs to buy a November Put Spread, 1220/1210 (Buy 1220 strike, Sell 1210 Strike). The Net Delta of this position at the time it is put on is: -.06 or just simple -6 deltas. The cost is, $3.85/contract. Since we know that futures contracts (or any underlying asset with options) holds a delta of 100 deltas. So in order to hedge against the -6 deltas on the Put Spread, would need to purchase 16.667 contracts of the 1220/1210 Put Spread. Since you can't buy less than a contract, we will round it up to 17 contracts. With the purchase of 17 contracts of the SPX Nov 1220/1210 Put Spread, you are not short 102 Delta's. It would cost you a total of $6,545 ($3.85 x 17 contracts x $100 contract multiplier). This is the part I'm not totally clear on....Would I just buy 1 ES Futures contract, since then I would be delta neutral, short only 2 Delta's (100-102) or would I buy 17 ES contracts?
Most market makers have a tolerance level of what they consider neutral. Very few look for "zero" deltas. A few +|- is fine.
Would they go out and my multiple contracts of ES then? Since they have about $10,400 worth of cushion from the max profit they can make on the Put Spread.
All the market makers in the SPX pit hedge with the SPX 500 future, whether the mini or the full size contract. None of them are concerned with deltas less than 1 emini (100 deltas). I think I can make this blanket statement. The vast majority of the MM's here are groups, very few individual locals. Typically as a MM aquires a position, he will imediatly hedge with futures. As he starts going long/short premium, gamma, etc, he will adjust his prices to require more edge to take a similar position. The "upstairs" manager of his postion may tell him we need to sell or buy premium. The manager may also shop what he needs to do with brokers in the pit. There is very little MM to MM trading in this pit. If you want to get out of a positon you generally do it through a broker. Many trades are of a very large size. The market maker's position is constantly moving. Any deltas anywhere close to 100 would be considered flat, and for many groups, much more than this.
They are trading purely for edge on the option volatility and are going to likely be making dozens more trades that day (most of which are likely larger in size) against a larger overall position.
There is no consideration of "max profit". Everything goes in the "mix" of thier postion. They are looking at their total delta gamma, theta, etc and what their max risk is if the market moves big.