OTC Options: How They Differ from Exchange-Traded Options and the Risks

Key takeaways

• OTC (over-the-counter) options are privately negotiated, customizable option contracts traded bilaterally rather than on an exchange.
• Strike prices, expiration dates, and other terms are not standardized—participants define terms to meet specific needs.
• OTC options carry higher counterparty and liquidity risk because they don’t clear through an exchange or trade on a secondary market.

What are OTC options?

OTC options are option contracts created and executed directly between buyer and seller, often with bespoke or “exotic” features not available in listed, exchange-traded options. They provide flexibility in contract terms—strike, expiration, payout structure, and even nonstandard conditions—so parties can tailor positions precisely.

How they differ from exchange-traded options

• Standardization: Exchange-traded options have standardized strike intervals and expiration dates and are fungible. OTC options are customizable and unique.
• Clearing and guarantees: Exchange trades clear through a clearinghouse that reduces counterparty risk. OTC contracts are private and do not enjoy clearinghouse protections.
• Liquidity and secondary market: Exchange options can be sold on the market. OTC options typically lack a secondary market; closing a position usually requires a negotiated offsetting trade with a counterparty.

Who uses OTC options and why

Both hedgers and speculators use OTC options when listed options cannot achieve the desired exposure or payoff cost-effectively. The ability to design specific payoffs, maturities, and strike relationships makes OTC attractive for tailored risk management and complex strategies.

Major risks

• Counterparty/default risk: Because OTC contracts depend on the counterparty’s ability to perform, one party’s default can cause losses and propagate through chains of contracts. Large defaults can have systemic effects.
• Illiquidity: With no standardized market for many OTC contracts, exiting positions can be difficult and costly—often requiring a matched offsetting trade.
• Lack of transparency and disclosure: Private terms and no centralized reporting can make it hard to assess exposures and valuation.
• No exchange protections: There’s no clearinghouse guarantee, margin framework, or standardized regulatory safeguards offered by exchanges.

Example: When a major counterparty fails, parties that relied on it for hedges or funding can be left unprotected, forcing them to unwind or default on their own obligations—creating cascading losses across other counterparties.

Regulation and market participants

Although the contracts themselves are private, brokers and market makers facilitating OTC trades are typically subject to regulation by agencies (for example, FINRA in the U.S.). Regulation can mitigate some risks but does not eliminate the fundamental counterparty and liquidity issues inherent in bilateral OTC contracts.

When to consider OTC options

OTC options can be appropriate for sophisticated investors who need customized exposures that listed options cannot provide. Before entering OTC trades, participants should:
* Assess counterparty creditworthiness and require contractual protections where possible.
Ensure they understand liquidity implications and how to close or hedge the position.
Consider valuation, reporting, and legal documentation (e.g., master agreements and collateral arrangements).

Conclusion

OTC options offer flexibility and customization beyond exchange-traded options, making them useful for tailored hedges and complex strategies. That flexibility comes with increased counterparty, liquidity, and transparency risks. Careful counterparty selection, contractual safeguards, and a clear exit plan are essential when trading OTC options.