OTC Options: Difference From Standard Options, Risks

What are OTC Options?

OTC options are exotic options that trade in the over-the-counter market rather than on a formal exchange like exchange traded option contracts.

Understanding OTC Options

Investors turn to OTC options when the listed options do not quite meet their needs. The flexibility of these options is attractive to many investors. There is no standardization of strike prices and expiration dates, so participants essentially define their own terms and there is no secondary market. As with other OTC markets, these options transact directly between buyer and seller. However, brokers and market makers participating in OTC option markets are usually regulated by some government agency, like FINRA in the U.S.

With OTC options, both hedgers and speculators avoid the restrictions placed on listed options by their respective exchanges. This flexibility allows participants to achieve their desired position more precisely and cost-effectively.

Aside from the trading venue, OTC options differ from listed options because they are the result of a private transaction between the buyer and the seller. On an exchange, options must clear through the clearing house. This clearing house step essentially places the exchange as the middleman. The market also sets specific terms for strike prices, such as every five points, and expiration dates, such as on a particular day of each month.

Because buyers and seller deal directly with each other for OTC options, they can set the combination of strike and expiration to meet their individual needs. While not typical, terms may include almost any condition, including some from outside the realm of regular trading and markets. There are no disclosure requirements, which represents a risk that counterparties will not fulfill their obligations under the options contract. Also, these trades do not enjoy the same protection given by an exchange or clearing house.

Finally, since there is no secondary market, the only way to close an OTC options position is to create an offsetting transaction. An offsetting transaction will effectively nullify the effects of the original trade. This is in stark contrast to an exchange-listed option where the holder of that option merely has to go back to the exchange to sell their position.

OTC Option Default Risk

OTC defaults can quickly propagate around the marketplace. While risks of OTC options did not originate during the financial crisis of 2008, the failure of investment bank Lehman Brothers provides an excellent example of the difficulty of assessing actual risk with OTC options and other derivatives. Lehman was a counterparty to many OTC transactions. When the bank failed, the counterparties to its transactions were left exposed to market conditions without hedges and could not, in turn, meet their obligations to their other counterparties. Therefore, a chain reaction took place, impacting counterparties further away from the Lehman OTC trade. Many of the affected secondary and tertiary counterparties had no direct dealings with the bank, yet the cascading effect from the original event hurt them as well. This is one of the major reasons that led to the severity of the crisis, which ended up causing widespread damage to the global economy.