Over the Counter (OTC) Options: Meaning, Types and Features

Over the Counter (OTC) options are financial contracts that are traded directly between two parties, rather than being listed on a formal exchange. OTC options are often used to hedge against risks in the underlying assets, and they offer a high degree of customization and flexibility. 

There are two main types of OTC options: calls and puts. A call option gives the holder the right, but not the obligation, to buy an underlying asset at a specified price, while a put option gives the holder the right to sell an underlying asset at a specified price. The features of OTC options include custom strike prices, expiration dates, and underlying assets, as well as the ability to trade in large sizes and the absence of exchange fees.

Keep reading this blog to know more. 

What Are OTC Options?

An Over the Counter (OTC) option is a financial contract that is tradable among private parties (over the counter). Traders use them when the options listed on the stock market do not fulfil their investment objectives. In short, Over the Counter Options are the outcome of the private transaction between the buyer and the seller.

Unlike other options, OTCs do not have a predetermined strike price and expiry date. The buyers and sellers involved in the contract set their own conditions, thus making it a versatile alternative to other derivative options. 

Moreover, a government agency regulates the market makers and brokers who take part in OTC markets, and there are no secondary markets for these financial assets.  

How Do OTC Options Differ from Exchange Traded Options?

To use exchange traded derivatives options, participants have to face several restrictions imposed by the exchanges. These entities standardise their strike prices and synchronise the expiry dates to match with the rest of the market. 

They also impose restrictions on the lot sizes in order to standardise them. However, in case of Over the Counter options, the exchanges cannot impose these measures. Here, the concerned parties decide the strike price and expiration dates according to their convenience.

Now, when it comes to liquidity, exchange traded derivatives have the upper hand. Due to their standardisation, they tend to gain liquidity over time. Thus, traders can exit their position by selling off their holdings in the secondary market. 

In case of OTC options, exiting a position can be challenging as one needs to find a buyer with similar requirements.  

Additionally, the settlement of exchange traded options is done via clearinghouses. This reduces counterparty risks by a significant amount. On the other hand, OTC options do not have such an advantage as there is no third party between the buyer and seller.   

Features of Over the Counter Options

The features of OTC options are as follows:

Self-Regulated

Individuals cannot take short or long positions in a secondary market for OTC options. Therefore, they must engage in multiple transactions to balance their profits and losses. Furthermore, buyers and sellers handle the clearing and settlement of transactions themselves, establishing inspections and mutual balances. These characteristics make the OTC market more or less self-regulated.

Flexibility

As OTC options allow traders to set their own expiry date and strike price, they form an attractive alternative to traditional options.

What Are the Different Types of OTC Options?

Just like exchange traded options, OTCs also have underlying assets. Now, depending on them, these financial contracts can be classified as follows:

• Equity Derivatives

Equity derivatives can have bonds, securities and commodities as their underlying asset. Futures, options, swaps and warrants are some of the common examples. 

• Interest Rate Derivatives

Interest rate derivatives are contracts which have interest rates, indices and instruments as their underlying asset. Interest Rate Options (IRO) and Interest Rate Futures (IRF) are the best examples in this regard. 

• Commodity Derivatives

Financial contracts having commodities as their underlying assets are called commodity derivatives. These can include both agricultural and non-agricultural commodities like gold, wheat, cotton, spices and more. 

• Credit Derivatives

These are derivative financial contracts where parties transfer credit risks to one another without selling the underlying asset. They are also called off-balance sheet financial instruments, and examples of them include Credit Linked Notes (CLNs) and Credit Default Swap (CDS). 

• Fixed Income Derivatives

In this case, fixed income securities like bonds, ETFs, debt mutual funds, etc., act as the underlying asset, and they generate a fixed income regardless of market conditions.    

• Currency Derivatives

Currency derivatives are futures and options contracts having currencies like INR, USD, etc., as their underlying security. They operate similarly to the stock futures and options contracts requiring a prefixed value and expiration date.   

Advantages of Over the Counter Options

Here are a few advantages of trading OTC options:

• OTC options are a perfect investment vehicle if you have specific investment goals. This is because the terms and conditions of the contract can be customised according to your requirements. 
• You can trade a variety of assets like derivatives, bonds, stocks and foreign exchange currency in the OTC market. Thus, it gives you a variety of options to trade with.   
• In case of unlisted companies, OTC assets allow trading at a lower cost and also with fewer restrictions. 

Disadvantages of Over the Counter Options

Listed below are a few of the disadvantages of OTC options:

• OTC derivatives contracts do not come not under stock market regulations. Thus, there is a high chance of counterparty risks and financial market instability. 
• There are no restrictions on contract terms and conditions, margins, leverages and positions. 
• Lack of standardisation, market forces, banking regulations etc., can have a significant impact on OTC options. 

Final Word

Over the Counter derivatives contracts have both pros and cons. So, if you decide to use them, please conduct a thorough market analysis and assess your investment objective as well as risk appetite.  

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