What are OTC Options?
Let me explain OTC options to you directly: these are exotic options that you trade in the over-the-counter market, not on a formal exchange like those standard exchange-traded option contracts.
Key Takeaways
Here's what you need to know right away about OTC options: they are exotic options traded in the over-the-counter market, not on a formal exchange like exchange-traded options. They come from private transactions between the buyer and the seller. Their strike prices and expiration dates aren't standardized, so you can define your own terms, and there's no secondary market for them.
Understanding OTC Options
You might turn to OTC options when the listed options just don't fit what you need. I find their flexibility appealing to many investors like you. There's no standardization for strike prices or expiration dates, so you and the other party define your own terms, and there's no secondary market. These options happen directly between buyer and seller, just like in other OTC markets. That said, brokers and market makers in these OTC option markets are usually regulated by some government agency, such as FINRA in the U.S.
With OTC options, both hedgers and speculators like you can sidestep the restrictions that exchanges impose on listed options. This flexibility lets you achieve your desired position more precisely and cost-effectively.
Beyond the trading venue, OTC options differ from listed ones because they're the outcome of a private deal between you as the buyer and the seller. On an exchange, options clear through a clearing house, which acts as the middleman. The market sets specific terms there, like strike prices every five points and expiration on a particular day each month.
For OTC options, you deal directly with the seller, so you can set the strike and expiration to match your individual needs. While not common, terms can include almost any condition, even some outside regular trading norms. There are no disclosure requirements, which means there's a risk that the counterparty won't fulfill their obligations under the contract. These trades don't get the same protection as those on an exchange or through a clearing house.
Finally, with no secondary market, the only way you can close an OTC options position is by creating an offsetting transaction. That offsetting trade will nullify the effects of your original one. This contrasts sharply with exchange-listed options, where you just go back to the exchange to sell your position.
OTC Option Default Risk
OTC defaults can spread quickly through the marketplace, and you should be aware of that. While the risks of OTC options didn't start with the 2008 financial crisis, the failure of investment bank Lehman Brothers shows you the challenge of assessing real risk with OTC options and other derivatives. Lehman was a counterparty in many OTC transactions. When the bank failed, its counterparties were left exposed to market conditions without hedges and couldn't meet their own obligations to others. This created a chain reaction, affecting counterparties further removed from the original Lehman OTC trade. Many of those secondary and tertiary counterparties had no direct dealings with the bank, yet the cascading effect hurt them too. This was a major factor in the severity of the crisis, which caused widespread damage to the global economy.
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