What are 'OTC Options'

OTC options are exotic options traded in the over-the-counter market rather than on a formal exchange. There is no standardization of strike prices and expiration dates, so participants essentially define their terms. As with other OTC markets, these options transact directly between buyer and seller. There is no secondary market.

BREAKING DOWN '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. 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 trading venue, OTC options differ from listed options because they are the direct result of a negotiation between the buyer and the seller. On an exchange, options must clear through the clearinghouse. This clearinghouse 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 and 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 also 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 clearinghouse.

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. In contrast, the holder of an exchange-listed option may merely 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 other side of its transactions, counterparty A, was left exposed to market conditions without hedges. These injured counterparties, in turn, could not meet their obligations to other counterparties. Therefore, a chain reaction took place, hurting counterparties further away from the Lehman OTC trade. Many of the injured counterparties had no direct dealings with the bank.

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