Exchange traded or Over The Counter (OTC) options

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Exchange-Traded Option

What is Exchange-Traded Option?

An exchange-traded option is a standardized derivative contract, traded on an exchange, that settles through a clearinghouse, and is guaranteed.

Understanding Exchange-Traded Option

An exchange-traded option is a standardized contract to either buy (using a call option), or sell (using a put option) a set quantity of a specific financial product, on, or before, a pre-determined date for a pre-determined price (the strike price).

Exchange-traded options contracts are listed on exchanges such as the Chicago Board Options Exchange (CBOE). The exchanges are overseen by regulators – including the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) – and are guaranteed by clearinghouses such as the Options Clearing Corporation (OCC).

Key Takeaways

  • An exchange-traded option is a standardized derivative contract, traded on an exchange, that settles through a clearinghouse, and is guaranteed.
  • Exchange-traded options contracts are listed on exchanges, such as the Chicago Board Options Exchange (CBOE), and overseen by regulators, like the Securities and Exchange Commission (SEC).
  • A key feature of exchange-traded options that attract investors is that they are guaranteed by clearinghouses, such as the Options Clearing Corporation (OCC).

Benefits of Exchange-Traded Options

Exchange-traded options, also known as ‘listed options’, provide many benefits that distinguish them from over-the-counter (OTC) options. Because exchange-traded options have standardized strike prices, expiration dates, and deliverables (the number of shares/contracts of the underlying asset), they attract, and accommodate, larger numbers of traders. OTC options usually tend to have customized provisions.

This increased volume benefits traders by providing improved liquidity and a reduction in costs. The more traders there are for a specific options contract, the easier it is for interested buyers to identify willing sellers, and the narrower the bid-ask spread becomes.

The standardization of exchange-traded options also enables clearinghouses to guarantee that options contract buyers will be able to exercise their options – and that options contract sellers will fulfill the obligations they take on when selling options contracts – because the clearinghouse can match any of a number of options contract buyers with any of a number of options contract sellers. Clearinghouses can do this more easily because the terms of the contracts are all the same, making them interchangeable. This feature greatly enhances the appeal of exchange-traded options, as it mitigates the risk involved in transacting in these types of securities.

Drawbacks of Exchange-Traded Options

Exchange-traded options do have one significant drawback in that since they are standardized, the investor cannot tailor them to fit their requirements exactly. Unlike OTC options – which are not standardized, but are negotiated directly between the buyer and the seller – exchange-traded options cannot be customized to fit the buyer’s or seller’s specific goals. However, in most cases, traders will find exchange-traded options provide a wide enough variety of strike prices and expiration dates to meet their trading needs.

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Exchange-traded versus Over-the-counter (OTC) Derivatives

An exchange traded product is a standardized financial instrument that is traded on an organized exchange.

An over the counter (OTC) product or derivative product is a financial instrument traded off an exchange, the price of which is directly dependent upon the value of one or more underlying securities, equity indices, debt instruments, commodities or any agreed upon pricing index or arrangement.

The most common types of derivative products are interest rate swaps, caps and their offshoots. Over 90% of commercial bank derivative trading is interest rate related due to the natural ebb and flow of their corporate finance and hedging activity.

The reason derivative products exist is that users often need customized products as the standardization of exchange products can lead to hedging mismatches and gap exposures.

The main differences between exchange and OTC products can be viewed as follows:

OTC Options

What are OTC Options?

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.

Understanding OTC Options

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.

OTC Option Default Risk

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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