Over-the-counter (OTC) options are exotic options not listed on public exchanges. That means that investors may not be able to buy them through their brokerage accounts.
Instead, investors trade OTC contracts directly, between the buyer and the seller, without using a third-party platform.
OTC Options Definition
As a quick refresher, options are derivatives that give holders the right to buy or sell stocks or other assets. An options holder can buy or sell the asset at a certain date at a certain price, for instance, and are always tied to an underlying asset. So, an options trader can buy options relating to, say Stock A, or Bond X.
While most options trade through brokers via exchanges, over-the-counter options trade privately, between a buyer and a seller. Over the counter options are sometimes tied to an exotic asset — a stock that may not be available for purchase through most brokers’ platforms.
OTC options may also lack standard expiration dates or strike prices, instead allowing for the two parties to define those terms on their own, making them appealing to those with a more complex options trading strategy.
How Does OTC Trading Work?
OTC securities include any types of investments that do not appear on U.S. exchanges. That can include stocks in foreign companies and small or mid-sized domestic companies, over-the-counter options and OTC futures. Some brokerages do allow investors to trade OTCs on their platforms, though not all do, and there may be additional fees charged by the broker to do so.
With that in mind, if you plan on investing in the OTC market, you may need to do some research beforehand to ensure that the brokerage account allows for OTC trading. Once you’ve found the appropriate broker or platform, trading is as simple as funding an account, and executing the trade.
What is the Difference Between OTC Options and Stock Options?
OTC options and regular old stock options, or listed or exchange-traded options, have some key differentiators worth reviewing. Here is a short rundown of those differences:
| OTC Options | Stock Options |
|---|---|
| Customized | Standardized |
| Illiquid | Liquid |
| No secondary market | Secondary Market |
1. Customization
A typical listed stock option is a standardized contract. The exchange, then, is determining expiration dates, strike prices, lot sizes, and other details. By standardizing contracts, exchanges can, as a result, increase the liquidity of the options contract.
Customization is the main and perhaps biggest difference between typical exchange-traded or listed stock options and OTC options. OTC options are customized with the terms hashed out by the involved parties.
2. Liquidity
OTC options are largely illiquid compared to their vanilla cousins. That’s because they’re more or less bespoke contracts — they’ve been customized according to the criteria set forth by the parties involved.
So, OTC options, with their customizations, may not be appealing to many traders, and as a result, not quite as easy to sell. In other words, there’s less demand for tailor-made options contracts like those in the OTC market, meaning they’re less liquid, and often more costly.
3. Secondary Markets
Another key difference between vanilla stock options and OTC options is the secondary market — or lack thereof, in the case of OTC options.
Primary markets are where investors buy fresh securities, when they’re first offered. Secondary markets are what most investors engage in when they’re buying or selling securities. These include exchanges such as the New York Stock Exchange.
While the primary market for OTC options is where parties meet to come to terms and develop an options contract, there is no secondary market. That means that there is one way to close an OTC option position, and that is by creating an offsetting transaction.
What are the Risks of Trading OTC Options?
Given the complex and bespoke nature of OTC options, trading them can come with some serious risks. Chief among those risks is the fact that OTC options lack the protection of exchanges. While exchange-traded or listed options are, once again, standardized, they are thus “guaranteed” by clearinghouses.
That means that they’re overseen, like other derivatives, by regulating authorities like the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The guarantee cements into place that contract buyers can exercise their options, knowing that the counterparty will fulfill their obligation.
This is also known as counterparty risk. Essentially, a contract is a promise between two parties. If one party decides not to follow through on their end of the deal, when it comes to a traditional stock option, then the exchange will ensure that everything is smoothed out. But OTC options lack that protection from the exchanges.
Pros & Cons of OTC Options Contracts
Like just about every financial tool, instrument, or security out there, OTC options have their benefits and disadvantages.
Pros
The biggest and most obvious advantage to OTC options is that they’re tailored for specific parties. That means that the parties engaged in the options contract get precisely the terms that they want and a contract that fits with their specific goals.
Further, the OTC market allows for trading of both securities and derivatives (like options) for small companies (exotic options) that aren’t listed on the typical exchanges. That gives investors and traders more options.
Effectively, the OTC market, and OTC options, provide investors with more investment choices. That can increase the risk – but also the potential rewards – of such securities.
Cons
The drawbacks of OTC options concern the lack of standardization of contracts (which may be a con for some investors), and the illiquid nature of the market. Plus, that illiquidity can add additional costs. And, again, there’s no secondary market for OTC options.
The big thing investors should remember, too, is that there can be a lack of information and transparency in the OTC market. Many OTC stocks are hard to dig up reliable information on, which adds to their risk profiles. The same holds true for OTC derivatives.
While with standard options, you can find data and availability through your broker’s portal, such information can be harder to come by for OTC options.
The Takeaway
There are some benefits to trading OTC options, but it requires a thorough understanding of how the market works and the risks that it presents. That said, going over-the-counter can open up a whole new slate of potential investments.
Opting for an options trading platform that offers educational resources, like SoFi’s, can help you continue learning to improve your investing know-how. Plus, SoFi’s platform boasts an intuitive design which allows investors to trade options either from the mobile app or web platform.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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