What Are Over-the-Counter (OTC) Options? How Do They Work?

Over-the-counter (OTC) options are a type of customized derivative not listed on public exchanges. That means they are typically not available for purchase through standard 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 holds the right, but not the obligation, to buy or sell the underlying asset at a certain price, on or before a specific date.

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 are not standardized, and allow both parties to define expiration dates and strike prices on their own.This can make 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; it can also include OTC options and 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. SoFi’s options trading platform does not currently support OTC trading.

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:

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.

The customizations OTC options come with may not be appealing to many traders and, as a result, may not be 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. In many cases, OTC options can only be closed through an offsetting transaction — a new trade with the original counterparty — that cancels out the existing position.

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 provided by clearinghouses on regulated exchanges, which essentially “guarantees” that the contractual obligations are fulfilled.

That means that typical exchange-traded options are 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, thus avoiding 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. This provides traders more investment choices, but introduces additional risks.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 securities, including stocks, lack readily available and reliable information. This increases their risk profiles.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.

While investors are not able to trade OTCs on the SoFi platform at this time, they can buy call and put options to try to gain exposure to exchange-traded stock movements or potentially manage risk.

That said, going over-the-counter can open up a whole new slate of potential investments.

Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.

Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.

FAQ

What is the difference between OTC and exchange options?

OTC options are traded over-the-counter (or, OTC), and may not be available to purchase through some brokerages or platforms. Exchange options, conversely, are traded on exchanges, and should be more widely accessible to investors.

How are OTC options priced?

Several factors influence the price of OTC options, and those could include the volatility of the underlying asset, the time to expiration, and applicable interest rates.

Photo credit: iStock/g-stockstudio

SoFi Invest®