Normally, if an investor wants to trade or speculate in options, he or she will peruse the options tables on their broker’s website. The various puts and calls for given security will be shown for different expiration dates, going out as far as a couple of years in the case of LEAPs.
These types of options are listed on an exchange and trade through a clearinghouse. Don't panic—it sounds more advanced than it is. Without going into the technical details, what it effectively means is that the performance of your option is guaranteed by the exchange itself.
Each participant is charged a fee to help cover potential default, with the odds considered remote. In other words, if you were to buy 10 call contracts giving you the right to buy a blue-chip company at $50 per share between now and a week from now, you would pay $3 per share, or $3,000 total (each call option contract represents 100 shares, so 10 contracts x 100 shares x $3 per share = $3,000).
If that company were to go to $60 per share, you could exercise the call options and pocket the profit—in this case, $60 sale price - $53 cost (consisting of $50 for the stock and $3 for the option) or $7 per share. Thus, a 20% rise in the company's stock resulted in a 133% gain on your options. The option you bought had to be sold by someone, perhaps a conservative investor who was selling covered calls as part of a buy-write transaction. They have to deliver the stock.
What happens if the other person, known as the counterparty, can’t? What if they died? Went bankrupt? That’s where the clearinghouse steps in and fulfills the contract. In essence, each of you was making a deal with the exchange/clearinghouse itself. Thus, there is virtually no counterparty risk.
How Over-the-Counter Options Differ from Regular Stock Options
In essence, over-the-counter options are private party contracts written to the specifications of each side of the deal. There are no disclosure requirements and you are limited only in your imagination as to what the terms of the options are. In an extreme example, you could structure an over-the-counter option with another party that required that person to deliver a set number of troy ounces of pure 24-karat gold based upon the number of whales spotted off the coast of Japan over the next 36 months. While that might be a very stupid transaction, you get the idea that you can write essentially any terms for these options.
The appeal of over-the-counter options is that you can transact in private and negotiate the terms. If you can find someone who doesn’t think your over-the-counter option proposal presents many risks to their side, you can get an absolute steal.
Counterparty Risk in Over-the-Counter Options
A major concern with over-the-counter options is that they lack the protection of an exchange or clearinghouse. You are effectively relying on the promise of the counterparty to live up to their end of the deal. If they can’t perform, you are left with a worthless promise.
Using the over-the-counter options is especially dangerous when used to hedge your exposure to some risky asset or security. When this happens, it is known as “basis risk”—your hedges fall apart, and you’re left exposed. That is why the world financial institutions panicked when Lehman Brothers failed in 2008—as a huge investment bank, they were party to countless over-the-counter options that would have entered a black hole of the bankruptcy court.
This is referred to in financial regulatory circles as a “daisy-chain” risk. It only takes a few over-the-counter derivative transactions before it becomes virtually impossible to determine the total exposure an institution would have to a given event or asset. The problem becomes even more complex when you realize that you may be in a position where your firm could be wiped out because one of your counterparties had their counterparty default on them, making them insolvent. It is why famed investor Warren Buffett had referred to unchecked derivatives as financial weapons of mass destruction.