Understanding Non-Equity Options: A Comprehensive Guide

A non-equity option is an option with an underlying asset that is something other than common stock. In most cases, non-equity options include indexes and commodities as underlying assets. It’s really a broad term to define a variety of options, provided the option doesn’t involve common stocks.

Non-equity options usually trade over-the-counter (OTC)Over-the-Counter (OTC)Over-the-counter (OTC) is the trading of securities between two counter-parties executed outside of formal exchanges and without the supervision of an exchange regulator. OTC trading is done in over-the-counter markets (a decentralized place with no physical location), through dealer networks. and come with a specific date on which they can be exercised.

Over-the-Counter Options

Trading options over-the-counter (OTC) affords the parties involved a lot of freedom. It is a private transaction, with a contract that meets the specifications of only the parties involved. No disclosure agreement exists. The terms for trading in such a way are endless and based entirely on the wants and needs of the individuals trading with one another.

OTC trading is appealing for several reasons. It’s done privately, with all negotiations, deals, and agreements being conducted between the parties involved. As long as both sides can eventually come to an agreement that suits all needs, there is the potential for great deals and significant profit once exercised.

The biggest issue with OTC trading of non-equity options is that it’s difficult to maintain liquidityLiquidityIn financial markets, liquidity refers to how quickly an investment can be sold without negatively impacting its price. The more liquid an investment is, the more quickly it can be sold (and vice versa), and the easier it is to sell it for fair value. All else being equal, more liquid assets trade at a premium and illiquid assets trade at a discount.. Options can’t always be closed out by selling them to someone else before the date of expiration. When traded OTC, one of the parties involved must find a different party to create an opposing contract with. It would then offset the initial contract/position and boost liquidity.

Functions of Non-Equity Options

Non-equity options are often sought out because of the factors mentioned in the section above. However, they’re also ideal for many investors because of how they function.

One of the most important functions that a non-equity option can fulfill is allowing an investor to hedge against price movements, thereby eliminating risk. The investor may be trading a number of other positions on exchangesTypes of Markets - Dealers, Brokers, ExchangesMarkets include brokers, dealers, and exchange markets. Each market operates under different trading mechanisms, which affect liquidity and control. The different types of markets allow for different trading characteristics, outlined in this guide and use the option to offset any losses that such investments may incur.

Non-equity options make sense because by helping an investor hedge against risk; they enable him to keep a well-balanced portfolio. He enjoys more freedom to execute trades and take positions, knowing that if the positions rise or fall in a significant way, he can use a non-equity option to restore the balance.

Trading Strategies

Non-equity options are afforded the same strategy options as exchange-traded options. Two or more options may be used together, and simple put and call strategies are possible as well.

Many options that are traded on exchanges, including currency options and gold options. They, of course, don’t enjoy the same flexibility as non-equity options, which are traded over-the-counter. The exchange – not the parties involved – establish the terms of the contract, what the strike prices Strike PriceThe strike price is the price at which the holder of the option can exercise the option to buy or sell an underlying security, depending onare, and when the options expire. They are why OTC non-equity options are often preferred because buyer and seller are free to negotiate every aspect of the transaction privately.

More Resources

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

• Futures and ForwardsFutures and ForwardsFuture and forward contracts (more commonly referred to as futures and forwards) are contracts that are used by businesses and investors to hedge against risks or speculate.
• Guide to Commodity TradingGuide to Commodity Trading SecretsSuccessful commodity traders know the commodity trading secrets and distinguish between trading different types of financial markets. Trading commodities is different from trading stocks.
• Options: Calls and PutsOptions: Calls and PutsAn option is a derivative contract that gives the holder the right, but not the obligation, to buy or sell an asset by a certain date at a specified price.
• Spot PriceSpot PriceThe spot price is the current market price of a security, currency, or commodity available to be bought/sold for immediate settlement. In other words, it is the price at which the sellers and buyers value an asset right now.