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Options are a form of derivative trading that is gaining more and more popularity as the year’s pass. They differ from traditional stocks because they derive their value from an underlying asset, which can be almost anything.
For example, if a customer purchases a Call option on shares of Facebook Inc., they have purchased the right to purchase 100 shares of Facebook Inc. at a predetermined price within a specific time frame. If, during this timeframe, Facebook’s stock price rises above this predetermined limit, the customer profits from the trade. Otherwise, they lose their initial investment.
The two major types of options: Listed and OTC
There are two major types of options: Listed and OTC (over-the-counter). Listed options are bought and sold through official stock exchanges, whereas OTC options are bought and sold between two parties.
Listed options
Listing requirements for options differ from country to country, but most have stringent regulations. In the UK, the Financial Conduct Authority (FCA) regulates all forms of derivatives trading, including stocks and options. The FCA has a set list of criteria that must be met before a company’s stock can be brought onto an official exchange. These include:
Over-the-counter options
On the other hand, OTC (over-the-counter) options do not meet any of these standards; they exist outside of all regulatory frameworks and thus face far less scrutiny. Trading in OTC options is done directly between two parties and can be extremely risky, as there is no governing body to monitor the transactions.
For example, one party might sell an option without even owning the asset from which it derives its value (selling “naked calls”, for instance). Or they might need to close their position before the expiry date because of some personal issue. In such cases, both parties lose money due to the failed transaction.
All this could have been avoided if both parties had traded on an official exchange using listed options. The FCA regulates all traders and ensures that customers are not taken advantage of through established legal requirements and rules. This makes trading worthwhile for customers and reduces the risk of failed transactions.
Key differences between listed options and OTC options
OTC markets do not comply with standardised protocols, making them more complex than listed alternatives. They also tend to be more expensive due to less competition and lower liquidity.
Listed derivatives provide transparency, simplicity and reduced costs because they are traded on formal marketplaces where investors can quickly negotiate prices and monitor positions.
Listed options are also slightly more flexible compared to OTC options. This means you can execute multiple trades at once, for instance, selling calls and puts with the same strike price and expiration date.
On the other hand, OTC traded contracts are typically traded by phone or electronically, one contract at a time. Furthermore, the option’s price cannot be computed using an analytic formula because there is no centralised exchange where orders are collated and executed simultaneously.
One important difference is the fragmentation in OTC markets, where products are traded across various providers. This means investors can’t access all available OTC options in one place.
With listed derivatives, on the other hand, there is only one broker that you would need to contact when trading your options. There are also fewer legalities involved are lower overall costs.
Listed options are much more transparent, more straightforward and cost-effective than OTC trades which any serious investor should consider. As long as you have a larger budget at your disposal, then it is always better to use listed contracts to get the best prices possible in any market conditions.
Summary
Trading with listed options is substantially safer than trading with OTC options. Trading through official exchanges ensures that the transaction will be completed, whereas unregulated trading can leave both parties at a loss. Beginner traders who want to know what is options trading should contact a reputable online broker from Saxo Bank to help them get started.