Over-the-Counter Options - Overview, Types and Benefits (2024)

Options contracts that are traded between private parties rather than on exchanges are known as over-the-counter options. OTC option agreements do not have the same procedure as exchange-traded options, which are originated and distributed through clearinghouses.

OTC Options Market Explained

When listed options don't fulfil their needs, investors turn to OTC options. Many investors are drawn to these alternatives because of their versatility. Because strike prices and expiration dates are not standardized, players basically create their own terms, and there is no secondary market.

These options, like other OTC markets, are traded directly between buyer and seller. Brokers and market makers who participate in OTC options markets, on the other hand, are normally regulated by a government agency.

The Objective of OTC Options

Hedgers and speculators can evade the restrictions imposed by their respective exchanges on listed options by using OTC options. Participants can reach their goal position more accurately and cost-effectively thanks to this flexibility.

OTC options differ from listed options in that they are the product of a private transaction with the buyer and the seller - in addition to the trading venue. Options on an exchange must pass via the clearinghouse. The exchange serves as a middleman in this clearinghouse phase. Strike prices, such as every five points, such as on a specific day of each month, and expiration dates are also decided by the market.

As buyers and sellers of OTC options deal directly with one another, they can customize the strike and expiration dates to match their specific requirements. While not common, words can refer to practically any condition, even those that aren't related to traditional trading or markets.

There are no transparency requirements, which means there is a chance counterparties won't follow through on their responsibilities under the options transaction. Furthermore, these deals are not protected in the same way that they are protected by exchange or clearinghouse.

Types of OTC Futures and Options

Based on the underlying assets indicated below, over the counter trading can be of the following types:

1. Interest Rate Derivatives

The underlying asset, in this case, is a conventional interest rate. Swaps are an example of interest rate OTC derivative trading because they involve an exchange of cash flows over a period of time.

2. Commodity Derivatives

Physical commodities such as gold, food grains, and other commodities are used as underlying assets in commodity derivatives. OTC trading in commodities derivatives is exemplified through forwarding contracts.

3. Equity Derivatives

The fundamental assets in equity derivatives are stocks. Options and futures are examples of OTC equity derivatives trading.

4. Forex Derivatives

The fundamental assets in forex derivatives are changes in foreign currency rates.

5. Fixed Income Derivatives

Fixed income securities are the underlying assets in this case.

6. Credit Derivatives

Without any underlying asset exchange, one party transfers credit risk to another. There are two types of credit derivatives: funded and unfunded. Credit Default Swaps (CDS) and Credit Linked Notes (CLNs) are two forms of credit derivatives traded over the counter.

Benefits of OTC Options

Here are some of the major benefits of over the counter trading:

• It allows small businesses to trade without having to be listed on a stock exchange. In comparison to corporations registered on stock exchanges, these businesses can benefit from lower financial and administrative expenditures.
• It can be utilized for hedging, trading risk transfer, and business operations leverage.
• It can provide more flexibility because corporations are not bound by the same set of rules as exchange-traded derivatives.
• It may enable businesses to offer consistent prices to their clients.