What are over the counter (OTC) options?

OTC options or over the counter options essentially represents options that are privately entered into and are not traded in a standard form in any stock exchange. In other words, you can look at over the counter options or OTC options as a class of options that are not standardized and are not exchange traded. Let us understand over the counter options with a simple example.

X is a tomato farmer and Y runs a ketchup factory. X wants to ensure the best price for tomatoes and Y wants a predictable cost for tomatoes as it would impact the profit margins on the ketchup. They can enter into a private contract where X has a put option to sell a fixed quantity of tomatoes to Y at a certain price. Y will charge a premium for this. The point to note is that tomato options do not trade on any recognized exchange so these would be OTC options. Now having understood what are OTC options, let us get into the nuances of OTC options and the OTC options definition.

Over the counter (OTC) options

OTC options or over the counter options can be defined as option contracts that are traded between private parties and not through recognized exchanges. Such private options contracts are popularly referred to as over the counter options or just OTC options. While exchange traded options are executed, cleared and settled through clearing corporations, there is no such mechanism for over the OTC options, although some of the countries are introducing a more organized mechanism for settling such OTC trades too.

How over the counter options or OTC options differ from exchange traded options?

We have already seen that exchange traded options are traded through an exchange while OTC options are normally traded between private parties. But there are some very important points of difference between OTC options and exchange traded options. Let us summarize a few key differences here.

1. Exchange traded options are normally standardized. How are they standardized. One way is that the strike prices or exercise prices are standardized. Secondly, the settlement cycles be it weekly or monthly are also standardized and synchronized with the rest of the market. The third way of standardizing is to standardize the lot sizes. For example, when you trade options on Reliance, you have to do it in minimum of 250 shares lots and in multiples thereof. In the case of OTC options or over the counter options, there is no such standardization involved. Each option is unique in its own way and it is designed and executing keeping in mind the specific and unique needs of the two parties. The only condition for OTC options is that the two parties should be agreeable to the terms of the contract and put their seals there to
2. The second difference is with reference to the secondary market liquidity. Now exchange traded options are standardized and tend to become liquid over time. Hence it is always possible to get a secondary market exit on such exchange traded options as there are a larger number of traders and fewer standardized products available. On the other hand, in the case of over the counter options or OTC options, secondary market liquidity is a major challenge. Take the case of the tomato farmer and the ketchup factor. If the seller of the option wants to get out of the option, the only choice is to get someone with similar requirements or you are stuck with the contract.
3. There is an important aspect of counterparty risk. In exchange traded options, the clearing corporation stands as the counterparty for each trade. For example, if M is the buyer and N is the seller of the option, then both effectively trade with the clearing corporation as the counterparty. In the event of any party defaulting, the liability of the defaulting party is taken over by the clearing corporation. This ensures smooth settlements without any hassles or defaults.

The OTC options market is popular only when the parties are large institutions where the reputation acts as the hedge. Also, to justify the cost of structuring OTC options, the ticket size has to be very large. That is why the OTC options market is restricted to the very large corporates and institutions only.

What are options?

An option is a contract that gives the buyer of the option the right without the obligation to buy or sell at underlying asset. Here are 3 important points about options to know.

• The buyer of the call option has the right to buy an asset without the underlying obligation. The seller of the call option has the obligation to sell if demanded for by the buyer.
• The buyer of the put option has the right to sell an asset without the underlying obligation. The seller of the put option has the obligation to buy if demanded for by the buyer.
• Since the buyer gets unlimited right without obligation, he has to pay a price called the option premium to the seller. The option price or option premium is the price of this right without obligation.

How to settle options?

Options in India are settled in cash. The profits or losses are adjusted. Options are settled at two stages. For sell options, there is daily settlement and final settlement of options.