Why do option traders take OTM options out of the position

A market maker has a hedged position and is long 50 Dec 40 calls and short 5,000 shares for delta neutrality. It's late in the afternoon on expiration Friday and the stock is trading at 40.00. The MM wants to buy 5,000 shares to cover his short, and decides to bid 39.97. Time passes, the stock trades as low as 39.98, but the MM buys zero shares. The stock closes at $39.98.

The MM has two choices:

Do nothing, and go home for the weekend short 5,000 shares

Exercise those OTM calls, and go home flat, with zero risk.

Which do you think the MM will choose? The decision is easy. He exercises. Of course, he can try to pay $39.98 in any after hours trading before exercising. But he doesn't have much time.

yeah I'm not really asking about ATM options at expiration, I'm more talking about if the trader was long 1000 Dec 75 calls and the stock was trading at 40 with a few days to expiration, a lot of times a market maker will choose to move these options to a different account a keep them separate from the rest of his book.

Ah a write off book, yes vol traders do that all the time for lottery tickets.

We'll have a discussion when I have more time later on.

Hi, options mkt maker here.

When we take teenie options onto the book a few days before expiry, it may be for a few reasons.

We have to cover any extreme movements as the exchange assigns an unreasonably high probability of excercise when calculating our margin call (they treat 1 delta options as 10 delta options for the sake of their bank account)

As they are 99% expiring worthless, funds that play directions will dump these options despite being worth money in terms of gamma (cheap way to get a little bit more gamma)

You also ask why we sometimes separate this. Well whenever a trade is separate from the front book (to the back book) this means that our delta position (and our hedging) will not take into account those teeny options. We might want to take a cheap punt (regardless of whether or not it expires ITM, if we move half way towards the strike, the options may become worth 3 ticks instead of 1. 300% return). As a market makers, our main book HAS to be delta neutral. Granted we can punt around a little bit and chose to run deltas to a degree but we have limits in terms of delta exposure. To wrap it up, we move trades to t he back book when we don't want to hedge and want to take a punt on the direction - We are a small market maker and for our main product we have between 15 - 30k options being amalgamated into a single line of greeks. When you have 20 other things to do, you don't want to have to keep calculating how many deltas to leave in order to keep your directional hedge active.

If you look at my book you will see something like this

FRONT/BACK1/BACK2/ROLLBACK/BARBELL1/COMBO1

All mkt making activity sat in front book, all prop positions managed separately in their own.

Hope this helps

Redrut,

Yes, that is the answer I was looking for and I think I understand it better now, thank you. So basically what you're saying is that if you're long 1000 1 tick calls before expiration you take those out of you're main book (this will leave you shorter a few delta that you buy back to remain delta neutral in your main book) now you have 1000 1 tick calls unhedged in a separate account. If the underlying goes lower then it's not really a big deal, those calls become worthless which was likely to happen anyways. But in the off chance that the underlying rallies enough you can sell those 1000 calls out at 3 ticks for a 300% return, AND you bought back the delta so the short hedge against the calls didn't eat away at that 300% return.