Options are versatile financial instruments that provide significant flexibility in managing risk and creating trading opportunities. In the UK, two main options are listed options and OTC (over-the-counter) options. Both offer investors different benefits depending on their individual goals and circumstances. This article will explore the key differences between these two options.
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Characteristics
Listed options are options contracts that are traded on an exchange. They provide standardised terms and conditions, including each contract’s expiration date and strike price. Clearinghouses may also cover these options to guarantee performance and minimise counterparty risk.
OTC options have fewer standardisation requirements, as they are negotiated between two parties directly without going through an exchange. OTC options generally have more flexible features than listed options, such as customised expiration dates or strike prices. However, these options tend to have higher counterparty risks since no central clearing house monitors the transactions.
Availability
Listed options are typically available from major stock exchanges such as London Stock Exchange (LSE) and the Euronext options market. Exchange trading options allow for greater liquidity as multiple parties trade options. It creates a more competitive environment for buyers and sellers to find the best prices.
On the other hand, OTC options are typically not available from exchanges but through options trading brokers in UK. These options are less liquid than those listed on exchanges due to their customised features and limited availability. For this reason, they often carry higher transaction costs than their listed counterparts.
Pricing
The pricing of listed options is determined by supply and demand forces in the marketplace. Due to their standardised terms and conditions, these options can be efficiently priced, with options pricing models such as the Black-Scholes model providing a good approximation of their value.
OTC options are not traded on an exchange and thus require customised pricing structures. Investors have to negotiate directly with options brokers or dealers to get an accurate price for these options, making them more time-consuming and costly than listed options. Additionally, OTC options generally carry higher transaction costs due to their limited liquidity and lack of standardisation.
Risk
Listed options provide traders with greater security since they are backed by central clearinghouses guaranteeing performance. These clearinghouses also monitor transactions to ensure they are conducted according to predetermined rules. As such, listed options provide traders with more counterparty risk protection than OTC options.
On the other hand, the lack of standardisation and central clearinghouse oversight in OTC options makes them more susceptible to counterparty risk. Additionally, since these options are traded directly between two parties, there is a greater risk of price manipulation or other fraudulent activities.
Regulation
Listed options are regulated by the UK Financial Conduct Authority and must adhere to specific rules and regulations. These include requirements for margin levels, trading hours and order types. As such, listed options provide investors with greater transparency and market oversight compared to their OTC counterparts.
OTC options are subject to different stringent regulations than listed options and thus may be subject to less oversight. It can expose investors to fraudulent activities such as market manipulation, insider trading and other market abuses.
Taxation
Listed options are generally subject to capital gains taxes at the point of sale. The UK tax authority also levies stamp duty on specific options contracts, which the buyer pays rather than the seller.
In contrast, OTC options commonly have different tax treatments depending on their features and the jurisdiction in which they are traded. As such, traders need to check with their options broker or dealer before engaging in trades to better understand applicable taxation rules.
Leverage
Listed options generally offer lower leverage levels than OTC options since they are traded through exchanges. It is due to regulations governing options trading that require investors to post margin before entering a trade.
In contrast, OTC options can offer higher leverage as buyers and sellers negotiate their terms outside the exchange. It can benefit options traders since it allows them to enter larger trades with less upfront capital.