Otcoptions

OTC Options vs. Standard Options: Differences and Key Risks

Key Takeaways

OTC options are exotic derivatives traded directly between parties, rather than on formal exchanges.
They offer custom terms but carry higher counterparty risk, as there's no clearinghouse.
Unlike listed options, OTC options lack a secondary market, requiring offsetting trades to close positions.
The 2008 financial crisis highlighted the systemic risks of OTC options due to potential default chains.
Wide term flexibility makes OTC options appealing for tailored strategies.
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What are OTC Options?

Over the counter (OTC) options are specialized financial instruments that trade directly between parties rather than on formal exchanges. These options offer flexibility because they are privately agreed upon between a buyer and a seller, allowing customizable strike prices and expiration dates.

Investors often use OTC options for tailored risk management strategies, but they must consider potential risks, such as counterparty default, due to the absence of standardization and regulatory oversight. We'll explain the unique features of OTC options, their advantages for sophisticated investors, and the significant risks involved.

How OTC Options Work and Their Unique Features

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.

The Risks and Default Concerns of OTC Options

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.

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FINRA. "OTCBB Frequently Asked Questions." Accessed April 7, 2021.

OTCMarkets. "FINRA/SEC Rules." Accessed April 7, 2021.

European Journal of Accounting, Auditing and Finance Research. "The Role of Over-the-Counter (OTC) Derivatives in Global Financial Crisis and Corporate Failures in Recent Times and Its Regulatory Impact," Pages 61-62. Accessed April 7, 2021.

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