What are Over the Counter (OTC) Options?
OTC Option Definition
Options that are traded between private parties in the over the counter market and not through exchanges are called over the counter options. While exchange traded options are executed and settled through clearinghouses, there is no such mechanism for over the counter option trades.
Exchange-traded Options
Options are rights to buy or sell an underlying asset at a fixed price, also called the strike price, on a preset date in future.
A call option is the right and NOT an obligation to buy an underlying asset at a predetermined price on a fixed date. A call to buy an asset is called a long position.
A put option is the right to sell an underlying asset at preset prices on a specific date. A call to sell an asset is called a short position.
In case of exchange-traded options, these preset prices and date on which the contract should be honoured, if the right of buy or sell is exercised, are more or less standardised and adhere to strict trading regulations.
Over The Counter Options
Unlike exchange-traded options, there are no standardised expiry dates or strike prices in over the counter option agreements. They are what the parties mutually decide them to be. In exchange-traded options, the last Thursday of every month is the date of expiration for all options contracts. But that is not the case with OTC options.
How Options are settled
Exchange traded options are settled through clearing houses. The exchange plays the market maker also when the trading volumes are low. But there is no clearinghouse to settle an OTC option. An OTC option is settled exclusively between the buyer and seller.
A significant disadvantage of the OTC option over the exchange-traded ones is that the exchanges where options are traded ensure there is a counterparty, that is, there is a seller for every buyer and a buyer for every seller at all price points.
Flexibility of terms
But investors go for OTC options when the exchange traded options do not meet their hedging requirements. Some also go to OTC for the flexibility of terms since the strike price, and date of expiry is not standardised in OTC options.
No standardised strike prices
In OTC options, there is no exchange or clearinghouse involved between the buyer and seller, and so they are free to set strike prices and expirations based on mutually agreed terms. When options are traded through exchanges, there might be certain limitations or regulations on how the strike price is calculated. But for OTC options, no such rules exist.
No disclosure requirement
There are also no disclosure mandates for OTC options, which make these type of options transactions less transparent and riskier in case the counterparty fails to honour their side of the deal. This can become risky when you enter into OTC option trades to hedge risks against investments in other risky assets. Exchange traded options are settled through a clearinghouse, which gives them an additional layer of security against payment defaults.
No secondary market
Unlike exchange-traded options, OTC options do not have a secondary market where they can short or long their positions on the exchange. Here the parties will have to enter into separate transactions or have lines of credit for counterparties to offset losses or leverage gains. Due to lack of regulations, OTC option agreements are more or less self-regulated. The checks and balances in terms of clearing and settlement are put in place mutually by the counterparties involved. The terms of business can be tweaked and customised to suit the interest of both parties.
Famous example of Default risks associated with OTC options
The scope of risks that OTC option transactions present first came to light with the collapse of Lehman Brothers who had been the counterparty to thousands of OTC transactions. When the bank fell, it defaulted and failed to honour hundreds of OTC option deals; it set off a dangerous chain reaction as these defaults caused the counterparties to Lehman to further default on their hedges or transactions with other counterparties.
