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Let's say I am running a fund and I want to place some bets on the market (i.e. speculate) or hedge my current positions.

Starting from this, what would be my incentives to go for exchange-traded products instead of OTC products, and vice-versa?

Of course exchange-traded products would not be ideal if I am into exotic derivatives. But assuming that I just want to buy/sell a given vanilla options, which is available on both types of market, does it make more sense to go OTC or exchange-traded?

My intuition is that if I go exchange-traded, I have less chances to get ripped-off as the price is "fairly" determined by the supply and demand law than if I go OTC. But in this case, why would vanilla options be traded OTC as well? Are they cheaper when being traded OTC (or different fees as well)?

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  • $\begingroup$ You are 100% right, it is a competitive open market that keeps people honest. (I personally avoid OTC only products for this reason.) $\endgroup$ – noob2 Jun 1 '17 at 16:20
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    $\begingroup$ (Possibly you can get vanilla options that are a little more customized when you go OTC, in terms of available strikes and maturity dates. But that is not a big advantage IMHO). $\endgroup$ – noob2 Jun 1 '17 at 16:25
  • $\begingroup$ @noob2 Thanks for your input! Yes you are right, I also forgot the fact that you can get taylor-made vanilla options on the OTC market. I have rephrased the question to avoid such distinction. $\endgroup$ – JejeBelfort Jun 1 '17 at 16:30
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    $\begingroup$ It is true that going through OTC channels might increase transaction costs. However, I believe a lot of exotic OTC is driven by funds that want to make their trade cheaper: for example, assume you want to bet on the S&P through an option and you have a very strong view that EURUSD will remain above 1.10 for the whole duration of the trade; then you can trade with a bank an hybrid OTC option on the S&P that knocks-out if EURUSD goes below 1.10. This will significantly lower the cost of your trade. $\endgroup$ – Daneel Olivaw Jun 1 '17 at 17:06
  • $\begingroup$ OTC trades do not necessarily a guarantor in between the 2 parties to assure payment will be made when it is due/owed. Clearing costs may be avoided, however, if SHTF you may regret trying to avoid that half of a basis point... $\endgroup$ – amdopt Jun 1 '17 at 18:50
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Here's some criteria: For example deal size, an exchange will trade a range of sizes from x to y and outside that you need OTC. Then there's value dates, an exchange will trade a range of standard value dates and outside that range you need OTC. Then there's the fact of one off or repeat business. If you've got a lot of repeat business you may prefer the OTC 1-to-1 relationship and advisory services compared with more anonymous trading on an exchange. I mean if your OTC counterparty continually rips you off on repeat business you're going to end the relationship, right? So the long term relationship is an incentive for you both to go OTC. There's nothing to stop lower fees for vanilla options (via a better spread band) if your counterparty knows you're going to be trading a lot. On that subject your credit arrangements, collateral agreements and margin costs may also be a criteria between the 2 choices.

So I guess if you have standard products to trade and see no benefit from a long term relationship with any 1 counterparty, go exchange, otherwise investigate your OTC options.

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