OTC Options
What are OTC Options?
OTC options are exotic options that trade in the over-the-counter market rather than on a proper exchange like exchange traded option contracts.
Figuring out OTC Options
Investors go to OTC options when the listed options don't exactly address their issues. The flexibility of these options is appealing to numerous investors. There is no standardization of strike prices and expiration dates, so participants basically characterize their own terms and there is no secondary market. Likewise with other OTC markets, these options execute directly among buyer and seller. Be that as it may, brokers and market makers participating in OTC option markets are normally regulated by some government agency, as FINRA in the U.S.
With OTC options, the two hedgers and speculators keep away from the limitations placed on listed options by their particular exchanges. This flexibility permits participants to accomplish their ideal position all the more unequivocally and cost-effectively.
Beside the trading scene, OTC options vary from listed options since they are the consequence of a private transaction between the buyer and the seller. On an exchange, options must clear through the clearing house. This clearing house step basically places the exchange as the middleman. The market likewise sets specific terms for strike prices, like each five points, and expiration dates, like on a specific day of every month.
Since buyers and seller deal directly with one another for OTC options, they can set the combination of strike and expiration to meet their individual requirements. While not run of the mill, terms might incorporate practically any condition, including some from outside the domain of standard trading and markets. There are no disclosure requirements, which implies a danger that counterparties won't satisfy their obligations under the options contract. Likewise, these trades detest a similar protection given by a exchange or clearing house.
At long last, since there is no secondary market, the best way to close an OTC options position is to make a offsetting transaction. An offsetting transaction will effectively invalidate the effects of the original trade. This is as a conspicuous difference to an exchange-listed option where the holder of that option only needs to return to the exchange to sell their position.
OTC Option Default Risk
OTC defaults can rapidly proliferate around the marketplace. While risks of OTC options didn't begin during the financial crisis of 2008, the disappointment of investment bank Lehman Brothers gives a magnificent illustration of the difficulty of surveying genuine risk with OTC options and other derivatives. Lehman was a counterparty to numerous OTC transactions. At the point when the bank failed, the counterparties to its transactions were allowed to be uncovered to market conditions without hedges and proved unable, thus, meet their obligations to their other counterparties. Therefore, a chain reaction occurred, influencing counterparties further away from the Lehman OTC trade. A considerable lot of the impacted secondary and tertiary counterparties had no direct dealings with the bank, yet the flowing effect from the original event hurt them too. This is one of the major reasons that prompted the seriousness of the crisis, which ended up making inescapable damage the global economy.
Features
- OTC option strike prices and expiration dates are not normalized, which permits participants to characterize their own terms, and there is no secondary market.
- OTC options are exotic options that trade in the over-the-counter market rather than on a proper exchange like exchange traded option contracts.
- OTC options are the consequence of a private transaction between the buyer and the seller.
