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Why Systematic Traders May Choose OTC Options

Article Quant Q&A · Author: Vladimir Nabokov
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Summary

The document compares liquid over-the-counter options with exchange-traded index options for systematic trading. It identifies market depth and trading costs as potential advantages of OTC markets, and notes that swaptions are generally traded OTC because their exchange-traded market is described as illiquid.

OTC contracts can be tailored to specific maturities and underlying tenors. They may also be executed alongside a spot or forward hedge, using the forward rate applied in option valuation, which can establish delta neutrality at entry. Exchange-traded options and their hedges must be placed separately, creating a risk of price slippage between the transactions. These are general considerations rather than a quantified comparison: the document gives no cost data, performance results, or discussion of counterparty, collateral, or operational risks. Suitability therefore depends on the instrument and the trader’s market access.

Key ideas

  • OTC options can offer greater liquidity and lower trading costs in some markets.
  • Swaptions are generally traded OTC because the exchange-traded market is described as illiquid.
  • OTC contracts allow customization of maturity dates and underlying tenors.
  • An option and its spot or forward hedge may be transacted together to target delta neutrality at entry.
  • Separate exchange-traded option and hedge orders can experience price slippage between executions.

Tags

OptionsVolatilityExecutionMarket microstructure
Full text
# Benefits of systematically trading OTC options instead of exchange-traded options


# Benefits of systematically trading OTC options instead of exchange-traded options












Is there a case to trade liquid OTC options (FX, single-name equity, swaptions, etc.) instead of exchange-traded index options in a systematic strategy?

## Answer by Chris Taylor (score 2, accepted)

https://quant.stackexchange.com/a/41637

The market is bigger and more liquid, hence trading costs are generally lower. In the case of swaptions you must trade OTC, the on exchange swaption market is not liquid at all.

You can get more customisation (eg of maturity dates, tenor of underlying) with an OTC transaction.

You can generally place an OTC transaction ‘with hedge’ ie you enter a spot or forward transaction at the same time as the option, using the same forward rate that’s used to value the option, such that you are delta neutral when you enter the position. With an exchange traded you need to place the deals separately, and yhere can be price slippage between the option and hedge transactions.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.