Over-The-Counter and Exchange Traded Options Compared

08 June of 2016

Did you know that options can be traded both on certain exchanges, and with over the counter brokers? Below, we focus on over-the-counter (OTC) and exchange traded binary options, and put them under the spotlight. This should help you decide which trading style might suit your needs most.

From commodity trading through to individual stock prices and even forex, options (both vanilla and binary options) offer traders the potential to put their knowledge to work and strike a position across a huge list of assets. But whatever it is that’s traded, all binary options (rather than vanilla) share one key feature: at expiration of the option, there are only two potential outcomes: A fixed payout or nothing at all.

Whether you open a binary option contract that was issued directly to you (i.e. an ”OTC” binary option) – or if you’ve purchased an option that was originally issued to another party (which is effectively what the exchange traded market involves), this “All or nothing” principle remains the same. So  if the trade finishes “in the money” when the option ends, you gain the fixed amount as laid out prior to placing the trade.

In addition, both OTC and exchange traded binary options are easily accessible to individual retail traders via simple, but feature rich, online platforms.

So initially, it might seem that there is little difference between OTC and exchange traded investments. There are, however, several key differences – particularly  when it comes to how the marketplace is set up. Read on for a summary of the main features of each trading choice;

OTC Binary Options

For individual traders, OTC binary options first became available in around 2008, when online platforms first started providing their own options. A review of these platforms illustrates that these firms offer prices for almost any tradable financial product, including etfs and even political votes. Positions can be opened long or short and the fixed return is known before the trade is confirmed.

The strength of this type of investment – particularly for non-professional traders – is the opportunity to take a position on assets in a simple and relatively straightforward way. The fixed return and defined expiry are the key elements of this. Where these two features are not present (from a spot market instrument, for example), it throws up lots of additional complexities for retail investors to weight up, such as how to organize and automate an exit point and when to discover, and stop, a losing run. With a binary option however, the focus is drawn to three areas: the price trends to take a position on, the value of the investment and the strike price. The dilemma of knowing if or when to get out, or to hold on to the investment is removed from the equation.

Exchange Traded Binary Options

During their early days, over the counter binary options came under intense scrutiny among certain parties, not least because regulatory bodies appeared unsure whether to treat options as a financial product to be regulated as normal – or as a form of gaming. Criticism has also focused on how OTC trading platforms make money – as the counter-party to the client positions: in short, the trader is always ‘betting against the house’.

Exchange traded binary options provide an alternative method of investing in the same instrument. In 2007, the Options Clearing Corporation amended its rules to allow binary options to be traded, which means it became possible for options to be traded on several regulated exchanges, including the IG group in the UK, and the CBOE and Nadex in the US

With exchange traded options, the fundamentals remain – that each binary option contract has a set payout, but the price of that trade changes, based on what other traders are willing to pay for it. In contrast to the OTC market where the broker is the counter-party, with exchange trades, the exchange acts as the middleman, matching individual buyer with individual seller. For the matching service, a commission is charged. Usually in the form of a ‘spread’.

Choosing between the Two: What to consider

  • OTC binary options offer the easiest route into the market. It is simple to quickly view what trades are available and place a trade. Conversely, the more complicated pricing model for exchange-traded options offers the prospect of being able to use option-pricing models and strategies to trade based on whether a particular option is under or overpriced. For a more experienced trader therefore, the exchange-traded model adds an extra level of analysis and further opportunities to generate value and profits.
  • Trading ‘Against the house’ is not an issue when trading with an exchange. The pricing is therefore not skewed against traders and instead is determined by the market itself.
  • Exchanges are generally more tightly regulatedthan OTC platforms and are required to follow rigid rules regarding service standards and handling of trader funds and accounts. Bear in mind, however, that many OTC brokers are now also fully regulated, reducing this particular risk.
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