What Are Over The Counter Options?

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  • 06 Oct 2023
What Are Over The Counter Options?

Let’s start with the otc meaning. An over-the-counter (OTC) option is a financial instrument that can be traded between two individuals. When the stock market's listed options fail to meet their investing goals, traders turn to OTC. In a nutshell, Over-the-Counter Options are the result of a personal transaction between the buyer and the seller.

OTCs do not have a fixed strike price or expiration date. Both buyers and sellers can customise the contract, making it a flexible substitute for other derivative options. Furthermore, there are no secondary markets for these financial assets. However, a market regulator oversees the market makers and brokers who participate in OTC markets.

On the basis of the underlying asset from which the value is created, OTC Contracts can be broadly categorised into the following categories.

Interest rate derivatives:

In this category a particular interest rate serves as the underlying asset. OTC derivatives with an interest rate component include Swaps, government security (G-Sec) bonds, Swaps etc.

Commodity derivatives:

Physical commodities like wheat or gold are the underlying for commodity derivatives like forwards contracts.

Forex derivatives:

Changes in the foreign exchange rates of two currencies are the underlying assets for forex derivatives.

Equity derivatives:

Equity-based securities are the underlying asset in these kinds of derivatives. Options and futures some well-known example.

Fixed Income:

Securities with a fixed income make up the underlying for an OTC contract.

Credit derivatives:

Without transferring the underlying, they move the credit risk from one party to another. These credit derivatives can be funded or unfunded. For instance, credit linked notes (CLN) and credit default swaps (CDS).

Here are the key features of over-the-counter options.

Flexible Terms

Investors turn to OTC options when exchange traded options fall short of their hedging needs. Some choose OTC because the conditions are more flexible because OTC options do not have standardised strike prices or expiration dates.

No specified striking pricing.

There is no exchange or clearing house between the buyer and seller of OTC options. So, they are free to decide on the strike price and expiration dates depending on their mutual agreements. There may be restrictions or rules on how the strike price is determined when options are traded on exchanges. Yet there are no such regulations for OTC options.

Option Settlement

Exchange traded option settlement is done through clearing houses. The exchange serves as a market maker when trading volumes are low. OTC options, however, have no clearing house. The only parties that can choose an OTC option are the buyer and seller.

The exchanges where options are traded guarantee that there is always a counterparty. This basically refers to a seller for every buyer and a buyer for every sale, regardless of price.

No disclosure is required

Over-the-counter options have no statutory disclosure requirements. This reduces the risk involved in these transactions if the counterparty is unable to uphold their end of the deal. It can be dangerous to begin trading over-the-counter options to protect yourself against derivatives in other risky assets. Exchange-traded options are settled by way of a clearing house, which provides additional insurance against payment defaults.

No secondary market

OTC options do not have a secondary market where they can short or long their positions on the exchange, unlike exchange-traded options. To offset losses or leverage gains, the parties will need to engage in additional transactions or establish lines of credit for counterparties. OTC option agreements are largely self-regulatory due to a lack of restrictions. The counterparties mutually establish the checks and balances for clearing and settlement. The parameters of the agreement can be modified to serve the needs of both the parties.

Let us know how the OTC and exchange traded are different.

  1. Options traded on exchanges and over-the-counter (OTC) options are different. Unlike regular contracts, over-the-counter agreements are made between two private parties. Contrarily, exchange-traded contracts have fixed parameters for the strike price, expiration date, settlement process, lot size, and even the margin requirements.

  2. There is no requirement for any disclosure because the agreement is between two private parties. Pricing and contractual obligations, as well as the conditions of the deal, are considered confidential information. Exchange-traded contracts, on the other hand, are exchanged electronically. All information on transactions, such as open interest volume and price, is made available to the public.

  3. Due to the opaque nature of over-the-counter option contracts and the involvement of third parties it is difficult to confirm the validity of transactions. OTC options become exceedingly illiquid due to this barrier. In addition, there is no secondary market to save them. On the other hand, exchange traded options are publicly traded, very liquid, and all trades are documented and cleared through clearing houses.

  4. Counterparty default risk is the main disadvantage of an over-the-counter option contract. Considering that it was a private arrangement between two individuals. At the time of contract maturity, there is no reliable means to make sure that the opposing parties complete their last responsibilities.

Here’s a table summarising the differences between the OTC and Exchange-traded options.

Trading venue

Exchange

Privately negotiated

Standardisation

Yes

No

Liquidity

High

Low

Transparency

High

Low

Counterparty risk

Low

High

Regulatory oversight

High

Low

Feature Exchange-traded options Over-the-counter options
Trading venue
Exchange
Privately negotiated
Standardisation
Yes
No
Liquidity
High
Low
Transparency
High
Low
Counterparty risk
Low
High
Regulatory oversight
High
Low

The following are the key benefits of trading OTC options.

  • If you are looking for a specific investment vehicle, OTC options are ideal. This is because the contract's terms and conditions can be tailored to meet your needs.

  • In the OTC market, you can trade a wide range of assets, including derivatives, bonds, stocks, and foreign exchange. As a result, it provides you with a wide range of trading possibilities.

  • OTC assets make trading in unlisted companies possible at a lower cost and with fewer limitations.

The following are some drawbacks of OTC options.

  • The absence of contract uniformity and the market's illiquidity are the drawbacks of OTC options. Moreover, the illiquidity may result in higher costs. Furthermore, OTC options have no secondary market.

  • Investors should keep in mind that the OTC market can occasionally lack transparency. The difficulty of finding trustworthy information about many OTC stocks raises the risk associated with them. In the case of OTC derivatives, the same is true.

  • While you can get data and availability for regular options through your broker's platform, it may be more difficult to do so for OTC options.

Conclusion

Today's financial markets rely heavily on the enormous over-the-counter derivatives market. They had a sharp increase between the 1980s and the early 2000s as a result of growing technology sophistication and financial literacy. They can be useful in risk hedging and online stock trading. Yet, they need to be traded efficiently. Or else,OTC can also lead to disastrous events or default.

FAQs On OTC Market

By opening a demat account and a trading account, you can engage in OTC derivatives trading in India. Also, you need to pick a brokerage house that offers OTC contracts.

In general, the over-the-counter market is unrestricted. Yet, the absence of a secondary market might cause liquidity issues for traders.

After the market hours have ended, you cannot actively trade Over-the-Counter options. When the market reopens, any trades you have placed will be performed in a queue.

Only forward contracts are exchanged over-the-counter between two parties. Whereas, futures are always traded on an exchange.

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