Non-Equity Options

Sep 03, 2022 By Susan Kelly

Non-equity options are derivative contracts that have an underlying asset other than equities. This is typically a stock index or physical commodity. However, almost any asset can be optioned in the OTC market. Fixed income securities, real property, and currencies can all be underlying assets.

Understanding Non-Equity Options

Options, much like other forms of derivatives, provide investors the opportunity to speculate on or hedge against the fluctuations of the assets that underlie the option. They also can use non-equity options to complete these trades on assets that do not trade on an equity exchange. The holder of a non-equity option can sell the asset at a predetermined price, but they are exempt from the duty to do so.

Non-equity options can also use all strategies that are available for exchange-traded options. These strategies include simple calls and puts, as well combinations and spreads that combine two or more options. Vertical spreads, strangle, and iron butterflies are examples of combinations and spreads. The exchange sets strike prices and expiration dates for exchange-traded options that are not equity options, such as currency options or gold options. The exchange can also set contract sizes. OTC versions are where the buyer and the seller decide all terms and become counterparties.

Options Contracts

A contract for options will typically identify the underlying asset and the price at which the asset may be traded. The term for this price is the "strike price." The date that the contract will be terminated is also specified. If the counterparties agree, a non-equity alternative might consist of ten ounces of palladium, one hundred thousand dollars in corporate bonds, or seventeen thousand dollars in bonds. An option on exchange-traded equities may cover up to one hundred shares. Everything is feasible so long as trading is allowed on the over-the-counter market.

A call option transaction is when a contract, or a series of contracts, is purchased from the seller or writer. The seller pays a premium to the buyer, and the seller is obligated to sell the shares at the strike price if the buyer exercises the option. A covered call is when the seller sells a call and holds the underlying asset. This means that the seller will still have the underlying shares to hand to the owner of the long-term call if they are called away.

Over-the-Counter Options

OTC gives the parties involved much freedom. This is a private transaction with a contract only the parties can agree to. There is no disclosure agreement. There are no set terms and conditions for trading in this way. They are determined solely by the needs and wants of those trading. OTC trading has many advantages. There is a chance for significant profit and great deals if both parties can reach an agreement that meets all their needs.

OTC trading non-equity options present the biggest problem. It's hard to maintain liquidity. Options cannot be sold to another person before expiration. OTC trading means one party must find another party to create an opposition contract. It would then be used to offset or increase liquidity.

Non-Equity Options: Functions

Because of the above factors, non-equity options can be sought after. They are also great for investors due to their functionality. A non-equity option allows investors to hedge against price fluctuations, eliminating risk. An investor might be trading on other exchanges and may use the option of offsetting any losses.

Non-equity options are good because they help an investor protect against risk and allow him to maintain a well-balanced portfolio. He has more control over trades and can take positions, knowing that if positions change in any significant way, he will be able to use a non-equity option to balance the portfolio.

Trading Strategies

You can combine two or more options, and simple put-and-call strategies are possible. Many options can be traded on exchanges. These include currency options and gold options. These options are not as flexible as other equity options that can be traded over the counter. The exchange sets the contract terms, not the parties, who determine the strike prices and when options expire. OTC non-equity options are preferred as the buyer and seller can privately negotiate all aspects of the transaction.

Take Note

OTC non-equity options have one major drawback: liquidity is unavailable because there is no way to close an option position before it expires. One party must find another party to create an opposite-option contract to offset the position. To partially offset the movement of the original asset, an investor can buy or sell another option within a similar area. The process for exchange-traded options is simpler as the investor only needs to offset the position on an exchange.

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