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Jane Goodwin

What are ETD and OTC Options?

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ETD and OTC options are derivative products where a contract is in place so that the holder of the option has the ability to exchange it for a specified underlying instrument, at a specified price, before or at a specified time. The difference between ETD and OTC options relates less to the nature of that contract. The abbreviation ETD stands for Exchange Traded Derivatives. An ETD option also sometimes referred to as a ‘listed option’ is one traded on a regulated exchange where the terms of the option contract are standardized by the exchange. The regulated exchanges include for example, the CBOE (Chicago Board Options Exchange) and London Metals Exchange (LME). The terms set by these exchanges might dictate if the option can be expired prior to expiry date or only at expiry date? What are known as ‘American Options’ allow the holder to exercise and convert to the underlying on or before expiration date whereas ‘European Options’ can only be exercised on expiration date. As well as the ETD option itself being traded on a regulated exchange the underlying instrument must also be listed on a regulated exchange. All of this regulation provides the benefit of ETD options being guaranteed against default through a clearinghouse. Over the counter options, OTC options, or as they are sometimes called, ‘exotic’ options, are a more bespoke product. The over the counter-reference correctly intimates that the nature of the transaction is one between two parties. Traders looking for particular terms might not be able to use ETD options to achieve their aim. For example, an investor might be looking to hold an option with a specific strike price or expiry date, one not provided in ETD form. Being able to define your own terms can have its advantages but typically this is accompanied by extra costs and is reflected in the buyer of the option paying a higher premium (price) to hold the option. Another potential downside is that the option writer (not the clearinghouse) is obliged to meet the terms of any exercised options. Credit risk plays a factor and is the reason that OTC options tend to be traded between institutions and banks.

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Exchange Traded Products are standardized financial instruments you can trade on an organized exchange. Over The Counter or derivative products are financial instruments traded away from exchanges.

Prices rest on values of one or more underlying commodities, equity indices, securities, debt instruments, or agreed upon arrangements or pricing indices.

The biggest difference, and crucial distinction, is the distinction of customization versus standardization. ETD product terms have a set standard. A clearing house gives you a guarantee the other side transaction meets their obligations in any transaction.

The clearinghouse takes on all contingent default risks, meaning neither side need not worry about the other’s credit status. In OTC trading transactions, such a guarantee does not exist.

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Hi Jane,

Two notable types of markets where derivatives are traded are: 

- Exchange-Traded Derivatives

- Over the Counter (OTC) Derivatives

ETDs are traded via a central exchange where the prices are visible to the public. 

On the other hand, trading OTCs derivatives involves two parties (bilateral negotiation) and doesn’t involve exchanges or other third parties. OTC stocks are traded through a dealer network instead of a centralized exchange. These stocks are called “unlisted” where the securities are traded through direct bilateral negotiation.

ETDs and OTCs are two different types of markets that reinforce each other and fulfil different clients’ needs. For example, ETDs involve better price transparency as opposed to OTCs. Additionally, exchange-traded derivatives involve lower counterparty risks as all of the trades are being settled on a daily basis with the clearinghouse. 

On the other side, over the counter markets are more flexible and might be a better choice for investors that place trades that don’t involve high order flow or specific demands. 
 

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