Over-the-counter options are options that are exchanged between private parties in the over-the-counter market rather than on exchanges. While exchange traded options are initiated and delivered through clearinghouses, OTC option deals do not have the same mechanism.
- Options are the rights to buy or sell an underlying asset at a fixed price (also known as the strike price) at a future date.
- A call option is the right, not the responsibility, to purchase an underlying asset at a predetermined price on a specific date at a predetermined price. A long position is a request to purchase an asset.
- A put option is the right to sell an underlying asset on a particular date at predetermined pricing. A short position is a request to sell an asset.
- In the case of exchange-traded options, these predetermined prices and dates on which the contract should be honoured if the right to purchase or sell is exercised are standardised and subject to tight trading laws.
Over-the-counter option agreements, unlike exchange-traded options, do not have regular expiry periods or strike prices. They are whatever the parties mutually agree on. The last Thursday of the month is the expiration date for all options contracts in exchange-traded options. However, this is not the case with over-the-counter options.
Clearing houses are used to settle exchange traded options. When trade volumes are low, the exchange acts as a market maker. However, there is no clearinghouse for OTC options. The buyer and seller are the only ones who decide on an OTC option.
The exchanges where options are exchanged assure that there is a counterparty, that is, there is a seller for every buyer and a buyer for every seller at all price points. This is a key disadvantage of OTC options over exchange-traded options.
Investors, on the other hand, prefer OTC options when exchange traded options fail to suit their hedging needs. Some people use OTC options for the flexibility of conditions, as the strike price and expiry date are not fixed with OTC options.
Because there is no exchange or clearinghouse between the buyer and seller in OTC options, they are free to determine strike prices and expirations on mutually agreed-upon terms. When options are traded on exchanges, the strike price calculation may be subject to particular restrictions or laws. However, there are no such limitations for OTC options.
There are no mandatory disclosure requirements for over-the-counter options, making these transactions less riskier if the counterparty fails to fulfil their end of the bargain. When you start into over-the-counter option trading to hedge risks against derivatives in other risky assets, this can become perilous. Exchange-traded options are settled through a clearinghouse, adding another layer of protection against payment defaults.
OTC options, unlike exchange-traded options, lack a secondary market where traders can short or long positions on the exchange. Participants will have to engage into multiple transactions or establish lines of credit for counterparties to balance losses or magnify gains. Due to a lack of constraints, OTC option contracts are more or less self-regulated. In respect of clearing and settlement, the participants involved established mutual balances and inspections. The contract's stipulations can be altered and adjusted to meet the demands of both parties.
The over-the-counter derivatives market is massive and vital to today's financial markets. From the 1980s to the early 2000s, they grew dramatically as a result of increasing financial knowledge and technological advancements. They can be effective in hedging risk and online stock trading but require precision since if not managed properly, they can result in catastrophic occurrences.
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