Options contracts that are traded between private parties rather than on exchanges are known as over-the-counter options. OTC option agreements do not have the same procedure as exchange-traded options, which are originated and distributed through clearinghouses.
When listed options don't fulfil their needs, investors turn to OTC options. Many investors are drawn to these alternatives because of their versatility. Because strike prices and expiration dates are not standardized, players basically create their own terms, and there is no secondary market.
These options, like other OTC markets, are traded directly between buyer and seller. Brokers and market makers who participate in OTC options markets, on the other hand, are normally regulated by a government agency.
Hedgers and speculators can evade the restrictions imposed by their respective exchanges on listed options by using OTC options. Participants can reach their goal position more accurately and cost-effectively thanks to this flexibility.
OTC options differ from listed options in that they are the product of a private transaction with the buyer and the seller - in addition to the trading venue. Options on an exchange must pass via the clearinghouse. The exchange serves as a middleman in this clearinghouse phase. Strike prices, such as every five points, such as on a specific day of each month, and expiration dates are also decided by the market.
As buyers and sellers of OTC options deal directly with one another, they can customize the strike and expiration dates to match their specific requirements. While not common, words can refer to practically any condition, even those that aren't related to traditional trading or markets.
There are no transparency requirements, which means there is a chance counterparties won't follow through on their responsibilities under the options transaction. Furthermore, these deals are not protected in the same way that they are protected by exchange or clearinghouse.
Based on the underlying assets indicated below, over the counter trading can be of the following types:
The underlying asset, in this case, is a conventional interest rate. Swaps are an example of interest rate OTC derivative trading because they involve an exchange of cash flows over a period of time.
Physical commodities such as gold, food grains, and other commodities are used as underlying assets in commodity derivatives. OTC trading in commodities derivatives is exemplified through forwarding contracts.
The fundamental assets in equity derivatives are stocks. Options and futures are examples of OTC equity derivatives trading.
The fundamental assets in forex derivatives are changes in foreign currency rates.
Fixed income securities are the underlying assets in this case.
Without any underlying asset exchange, one party transfers credit risk to another. There are two types of credit derivatives: funded and unfunded. Credit Default Swaps (CDS) and Credit Linked Notes (CLNs) are two forms of credit derivatives traded over the counter.
Here are some of the major benefits of over the counter trading:
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 executed and settled through clearinghouses, over-the-counter option deals do not have the same mechanism.
Trade between two individuals who buy and sell a share of a company that is not listed on an exchange is an example of an over-the-counter market. Any security, including equities, commodities, and derivatives, can be traded in an over-the-counter market.
Furthermore, the OTC market allows small businesses that aren't listed on traditional exchanges to trade securities and derivatives (such as options).
Usually, OTC stocks would be risky.
Futures are always traded on an exchange but forwards are only traded over-the-counter or as a signed contract between two parties. As a result, futures are generally uniform due to their exchange-traded nature, whereas forwards can be unique due to their over-the-counter nature.