OTC options are exotic options that trade in the over-the-counter market rather than on a formal exchange like exchange traded option contracts. Key Takeaways OTC options are exotic options that trade in the over-the-counter market rather than on a formal exchange like exchange traded option contracts. OTC options are the result of a private transaction between the buyer and the seller.
OTC option strike prices and expiration dates are not standardized, which allows participants to define their own terms, and there is no secondary market. 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. With OTC options, both hedgers and speculators avoid the restrictions placed on listed options by their respective exchanges.
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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 pricessuch as every five points, and expiration datessuch as on a particular day of each month. While not typical, terms may include almost any condition, including some from outside the realm of regular trading and markets. There are no disclosure requirementswhich 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 marketthe only way to close an OTC options position is to create an offsetting transaction.
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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. While risks options exchange traded over the counter OTC options did not originate during the financial crisis ofthe 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. Therefore, a chain reaction took place, impacting counterparties further away from the Lehman OTC trade. 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.