OTC Equity Option

A custom, bilaterally negotiated option

A privately negotiated right — not an obligation — to buy or sell a share, a basket or an index at an agreed strike on an agreed date. Everything a listed contract fixes for you is negotiable here: the strike, the size, the expiry, the underlying and features such as barriers. The price of that flexibility is that the contract exists only between the two parties who signed it, with no exchange or clearing house standing behind it.

Open in the app · Equity · intermediate

The lesson

1. What it is

A right to buy or sell a stock, basket, or index at a strike price, negotiated bilaterally rather than traded on a listed exchange. The buyer pays a premium for that right and can walk away from it; the seller has no choice but to perform if the buyer exercises.

2. How it’s priced

Value comes from the underlying price, the strike, time to expiry, dividends, interest rates and — above all — implied volatility. Dealers quote and manage these positions in volatility terms, hedging the delta as the underlying moves. Because the delta changes as the price moves, that hedge has to be adjusted continually rather than set once.

Index options carry a pronounced skew: puts struck below spot trade at a higher implied volatility than calls struck the same distance above, a pattern that has held since the 1987 crash.

3. Why it’s used

OTC options allow tailored strikes, expiries, notionals, and exotic features (like barriers) for hedging concentrated positions or bespoke payoffs. A shareholder who needs protection on an exact number of shares to an exact date can buy it, rather than approximating the exposure with standard listed contracts.

4. Key terms

Strike, expiry, underlying, premium — plus exotic features like knock-in/knock-out barriers or basket underlyings not available on listed markets. Sensitivities are tracked through the Greeks: delta, gamma, vega and theta.

Vega is quoted per volatility point: a book showing $40,000 of vega gains roughly $40,000 if implied volatility rises from 20 to 21.

5. Risks to watch

There is no clearing house standing behind the trade, so each side carries the other’s credit risk. Bespoke contracts are hard to exit before expiry, barrier features can terminate a hedge at the worst possible moment, and sellers face losses far exceeding the premium.

The uncleared margin rules now require in-scope dealers and funds to exchange initial and variation margin on bilateral options, which limits — but does not remove — that credit exposure.

A founder puts a floor under a concentrated holding

A founder holds 2m shares trading at $40 — a position worth $80m.
She buys a one-year OTC put struck at $36 on the full 2m shares.
The premium is $2 a share, so $4m is paid upfront.
The stock ends the year at $28, so the put pays $36 − $28 = $8 a share, or $16m.
The shares are worth $56m, so the package is worth $56m + $16m − $4m = $68m.

Below the $36 strike the position is worth $68m however far the stock falls — a floor of $34 a share, the strike less the premium. Above $36 the put expires worthless and the $4m is simply the cost of the insurance.

Key terms

Strike — The price at which the option lets its holder buy or sell the underlying.
Premium — The amount paid upfront for the option, and the most a buyer can lose on it.
Implied volatility — The volatility figure that makes a model return the option’s traded price — the language dealers quote in.
Delta — How much the option’s value moves for a small move in the underlying, and so how much stock hedges it.
Vega — How much the option’s value moves when implied volatility changes by one point.
Barrier — A price level that brings an option into existence or extinguishes it if the underlying trades through it.

Every key term, A to Z

In practice

Company founders and executives use bespoke puts and collars to protect stock they cannot easily sell, and pension funds buy index puts to cap the drawdown on an equity book. On the other side sit dealers, who warehouse the risk and hedge it with listed options and the underlying shares.