Have you heard of an over-the-counter (OTC) market? This is just another investment opportunity to be aware of if you’re getting started or more involved as a trader. Here’s what you need to know about OTC markets.
What are OTC markets?
An OTC market is a market in which stocks and some other commodities can be traded. The difference is that unlike auction markets, trading “over the counter” means that securities are electronically traded directly between two parties without using a broker.
Several types of financial products and can be traded using an OTC market, including:
Are OTC markets the same as penny stocks?
There can be some confusion about whether OTC markets and penny stocks are the same thing. While penny stocks are traded exclusively on OTC markets, not everything in OTC markets are penny stocks.
The definition of a penny stock can vary, depending on who you ask. Generally speaking, it is commonly accepted that a penny stock is a small company with a share price that is less than $1. However, according to the Securities and Exchange Commission (SEC), penny stocks are any stock with a price that is less than $5 that is traded on an OTC market. Most often, penny stocks are priced low, with shares that could be even less than a penny.
OTC markets, on the other hand, are simply places where individuals or companies buy and sell shares. So even though there are penny stocks on OTC markets, there are also large international companies that are not considered penny stocks.
Risks Involved with Trading OTCs
As with any trading experience, there are risks involved with trading over the counter. One of the biggest risks is not knowing a lot of information about the companies that are in OTC markets. Since these companies aren’t on the national exchanges, like NYSE and NASDAQ, they aren’t bound to the same disclosure requirements. Instead, all the company needs to do to list on an OTC market is complete a listing form. This can make it difficult to figure out the true potential of OTC stocks.
Another major risk is that OTC markets are often thinly traded with wide bid-ask spreads. A bid-ask spread is the difference between the asking price and the bid price of an asset. To put it more simply, it’s the difference between the highest price that a buyer is willing to pay for the asset and the lowest price that the seller of the asset is willing to accept for it.
Overall, the companies that trade on OTC markets are generally valued at much less. Think of it this way — the companies that trade on formal national exchanges have a large market capitalization. This makes it so that it’s very unlikely for investors to significantly affect the price of a stock by trading it. However, OTC markets have a low market capitalization, meaning that the price of a stock can dramatically change, even with a relatively small trading volume. Since it’s much easier to change the price of a stock on OTC markets, it makes stocks traded on OTC markets much more vulnerable to manipulation and pump and dump schemes.
Finally, it’s important to keep in mind that there may be fewer buyers and sellers overall on OTC markets. If you buy a significant position in a stock, it’s always possible that it’ll be difficult to sell it in the future.
The OTC Markets Group
The OTC Markets Group is the largest U.S. marketplace for over the counter securities. As of 2019, it had over 10,500 securities listed. It provides services in three core areas:
- Trading services through the SEC-regulated Alternative Trading System called OTC Link ATS
- Access to market data on over 11,000 securities through channels including Bloomberg, REDI Technologies and Thomson Reuters
- Corporate services for companies to find solutions that allow them to better engage with and inform investors
The OTC Markets Group breaks down the OTC market into three tiers, each of which offers different levels of transparency and company requirements. It’s important to understand the three tiers so you know what you’re getting into if you decide to trade OTCs.
What is the OTCQX
OTCQX Best Market is the top tier marketplace for OTC stock trading. Stocks on this market have to meet the most stringent qualification criteria. To qualify for the OTCQX market, companies must:
- Meet high financial standards, like those required for continued listing on the Nasdaq Capital Market
- Follow best practice corporate governance
- Demonstrate compliance with U.S. securities laws
- Be current in their disclosure
- Have a professional third-party sponsor introduction
The strict requirements for this marketplace mean that companies in bankruptcy, shell companies, and penny stocks cannot qualify for a listing. Instead, the companies that you’ll find on OTCQX are often global household names.
What is the OTCQB
OTCQB Venture Market is geared more toward early-stage and developing companies, both in the U.S. and internationally. To qualify for a listing on this marketplace, companies must be current in their reporting and undergo an annual verification and management certification process. Any company that wants to be listed on this marketplace must also meet the $0.01 bid test.
Companies in bankruptcy cannot qualify for a listing on the OTCQB marketplace.
What is OTC Pink
Unlike the other tiers, the OTC Pink Open Market does not have any financial standards or disclosure requirements. This allows a wide variety of companies to trade on the market, including foreign companies that limit their disclosure in the U.S. You can also find penny stocks and shell companies on the Pink Open Market.
The lack of requirements to get listed on this market means that trading on OTC Pink opens you up to more risk. While there may be some worthy trading opportunities available, you could also run into delinquent companies that are unwilling or unable to provide information to investors.
Are OTC Markets the Right Trade for You?
OTC markets offer a more unstructured environment that may be preferred by some investors. If you’re used to trading on markets such as the New York Stock Exchange, trading on an OTC market could be a big change for you, and for some, an unwelcome one.
Generally speaking, if you’re new to trading or just starting to get your feet wet, you may want to hold off on trying out an OTC market. The more open atmosphere of these markets means that there’s more opportunity for fraud and unfair deals to occur. You may want to plan on doing your own research to ensure that you feel comfortable buying or selling an OTC stock.
OTC markets can be volatile and change rapidly depending on changes in the economy. Before you trade on an OTC marketplace, you should be aware that OTC markets don’t have regulations in place to protect investors if a financial crisis were to occur.
So, are OTC markets right for you? The bottom line is that it all comes down to your comfort level and your risk tolerance. Keep in mind that trading on an OTC market tends to involve more risk than trading on other national marketplaces. If you’re a savvy investor with a moderate or high-risk tolerance, you may very well yield desirable profits by trading on an OTC marketplace.
OTC markets present another investment opportunity for those that want to branch out and try something new. However, before getting involved, you should understand the differences between OTC marketplaces and national stock exchanges. While there are substantial risks involved with getting involved with an OTC marketplace, savvy investors just might find the risk well worth their time.
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