Tuesday, June 15, 2010

equity derivatives, from an OTC options perspective

* listed options (standardized contracts) are guaranteed by the exchange. Exchange is the counterparty of every trade. You don't need to know who the real counterparty is. Like futures, For every long position out there, there's a short position for the same contract. Exchange takes no outstanding position. No default risk. OTC options have credit risk, so credit needs checking. Collateral is required.
* OTC option is custom made, rather than standardized. If you want a specific option (some strike price, expiry...) you ask the banks. They each spend some effort (won't waste time if your order is small) to give you a quote.
* You might sell the option you bought. No restriction for listed. For OTC, your counterparty may disallow it. Remember it's a bespoke bilateral contract.
* Are there more calls than puts? Possible.
** For every long call, there's a short call.
** For every long put, there's a short put.
* eq deriv instruments include exchange-listed options, OTC options (ie buyer and seller both come to a broker/dealer to trade????), index futures, futures on individual stocks, swaps, but not convertibles.
** eq cash and eq deriv are separate trading desks.
* OTC option trading has no low-latency requirement since there's no exchange involved.
* Valuation (rocket science) is a shared module of option pricing and market risk.
* before an eq deriv trader places a trade, system lets her assess the aggregate risk exposure of the entire firm. Just like prime brokerage risk systems (GSS), EqDeriv Risk measures risk to the bank, not risk to the client. I think this means the bank is risking its own money, probably as a dealer not a broker.
* Futures contracts are obligations; options are one-sided obligations. How were financial futures invented? As hedging tools just like commodity futures. If your (short/long) position (in stocks or other assets) shows correlation to a futures, then the futures can reduce your risk, but also will limit profit potential. You can also use futures to lock in profit.

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