Investors typically browse option tables on their broker’s website if they wish to trade or speculate in options. Several options to buy and sell a particular security will appear for different expiration dates, extending even up to several years in the case of long-term options (LEAPs).
How do over-the-counter options differ from regular stock options?
At its core, over-the-counter options are private contracts between the two parties to the deal according to the specifications of each party. There are no disclosure requirements, and you are limited only by your imagination in terms of the terms of the options. In an extreme example, you could arrange an over-the-counter option with another party requiring them to deliver a specified number of ounces of 24-karat pure gold based on the number of whales spotted off the coast of Japan over the next 36 months. While that might be a very silly deal, you get the idea that you can write almost any terms for these options.
Counterparty risk in over-the-counter options
One of the main concerns with over-the-counter options is that they lack the protections of an exchange or clearinghouse. You are effectively reliant on the other party’s promise to fulfill their side of the deal. If they are unable to perform, you are left with a worthless promise.
Using over-the-counter options is particularly risky when used to hedge your exposure to risky assets or securities. When this happens, it is known as “basis risk” – your hedge unravels, leaving you vulnerable to risks. This is why global financial institutions collapsed when Lehman Brothers failed in 2008 – as a massive investment bank, it was a party to many over-the-counter options that would have entered a black hole in bankruptcy court. This risk is referred to as “cascade risk” in financial regulatory circles. It only takes a few over-the-counter derivative transactions before it becomes almost impossible to determine the total exposure that the institution would have to a particular event or asset. The problem becomes more complicated when you realize that you might be in a position where your company could be wiped out due to the inability of one of the counterparties to meet their obligations, rendering them insolvent. This is why famous investor Warren Buffett described unregulated derivatives as “financial weapons of mass destruction.”
Sources:
FINRA. “Regulatory Notice 13-39: Options and Margin Requirements,” Page 2.
Berkshire Hathaway. “2002 Letter to Shareholders,” Page 15.
Source: https://www.thebalancemoney.com/over-the-counter-options-358093
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