Finance: what is OTC (Over the counter)

welcome anyone to try to make the story even clearer. I'm happy with most of it, but the end of it could be a bit clearer.

"Bob makes money by selling and buying chocolate.

It's currently the beginning of October. Because Halloween is coming up at the end of the month, the price of chocolate bars is expensive because lots of people eat chocolate at Halloween and people are buying chocolate to give to trick-or-treaters. Chocolate bars in October currently cost $2.00 each. Bob thinks that after Halloween the price of chocolate bars will fall to $1.00 each because people will have eaten so much chocolate that they don't want to even see chocolate for another month.

Because of this Bob tweets that he is willing to sell 100 chocolate bars at $1.50 each.

Carol sees Bob's tweet and thinks "$1.50 per chocolate bar? Wow, that's a really good deal since chocolate bars cost $2.00 each."

Carol doesn't celebrate Halloween and she doesn't realize that Halloween could have an impact on the price of chocolate, so she sends Bob a direct message on Twitter saying that she will sign an agreement on paper that she will buy the 100 bars of chocolate for $1.50 each in November.

Bob and Carol have both just signed a futures contract, which is basically an agreement to buy or sell something to each other in the future for a price they decided on today.

After Halloween, the price of chocolate bars falls to $1.00 like Bob expected because nobody is buying chocolate bars from the store because they got tons from "trick-or-treating". On November 1st, Bob then buys 100 bars of chocolate from the store for $100 dollars.

Because Carol promised to Bob that she would buy the chocolate when she signed that agreement, she has to buy the 100 bars of chocolate for $1.50 each as she agreed to in the contract. Bob sells 100 bars of chocolate for $150. Since he just bought them for $100, that means that he just made $50 on the futures contract he signed with Carol.

Agreements like the one that Bob and Carol agreed to take place everyday in the futures market. The futures markets are a lot like stock markets except, instead of trading pieces of companies, people are trading commodities like beef, corn, steel, etc.

Some of these people do this because they want to make money like Bob did. Others do this to protect themselves. For example, MacDonald's might buy futures contracts on beef because they think the beef might get expensive in the future and they want to get a good price on beef today.

Whatever the product the people are trading, hundreds of thousands of these trades take place everyday.

Now OTC Derivatives are a lot like the futures contract that Bob negotiated with Carol and that people trade everyday.

Except instead of going to futures market, they instead negotiate directly. This is why it's called "over the counter." Like OTC medicines, there is no one that owns the market regulating how things are traded.

When Bob negotiated directly with Carol via Twitter, he basically made an OTC agreement because Bob and Carol did business with one another directly.

In real markets however, the people who are in the market just to make money speculating on how prices will change will never see the product they are signing an agreement on. Bob and Carol may never see the actual chocolate bars. Maybe Carol doesn't even like chocolate and are just buying the rights to buy chocolate because she thinks that she could have sold the chocolate bars to someone else at the $2.00 price of chocolate before Halloween.

When people are trading the right to buy or sell a product like chocolate, they are basically trading pieces of paper like "I.O.U.s" that can be exchanged for chocolate bars by anyone, but they never see the actual bars of chocolate themselves. When they do this, they are trading derivatives. Those agreements that are worth a certain number of chocolate bars derive their value from the number of chocolate bars that the final bearer, or holder, of the I.O.U.s can get.