- January 23, 2021
- Posted by: Stratford Team
- Category: Markets
OTC or over-the-counter trading offers opportunities, like buying a young company of great potential for a low price. But it’s also subject to major risks, like lack of regulations and difficulty of getting information.
- OTC (over-the-counter) refers to buying and selling securities outside of an official stock exchange.
- OTC investments can include penny stocks, bonds, derivatives, ADRs, and currencies.
- OTC trading can be profitable, but is highly risky — shares are thinly traded and volatile.
- Visit Business Insider’s Investing Reference library for more stories.
OTC (over the counter) is the stock market version of “for sale by owner.”
It’s a process by which stocks, bonds, and other financial instruments are traded directly between two parties instead of on a public stock market, such as the New York Stock Exchange (NYSE) or Nasdaq.
Investing in OTC securities has advantages, such as getting in on the ground floor of a winning stock. “With OTC, you have access to high-growth emerging companies, including startups,” says Michael Bertov, author of The Evergreen Startup.
And you get more bang for the investment buck too since prices are typically lower for OTC investments than for their public exchange counterparts.
Still, there are a lot of risks associated with OTC trading as well, from lack of regulation to volatile price swings.
Let’s look at the ins and outs of investing OTC.
What does OTC mean?
OTC markets are electronic networks that allow two parties to trade with each other using a dealer-broker as a middleman. They are known as dealer networks or markets. In contrast, stock exchanges are auction markets. A price for a stock is posted (the “ask”), and then investors make offers for it, bidding against each other.
Companies that trade OTC are considered public but unlisted. This means their stock can be openly bought and sold, but that the stock is not listed on a major exchange such as the NYSE or NASDAQ. So these equities are subject to the rules and requirements that these exchanges impose on their listed companies. No governing institution is watching them, in other words.
That said, there are still federal regulatory hoops to jump through. Many OTC stocks are subject to at least some oversight by the SEC. In fact, SEC regulations were updated in September 2020 to enhance disclosure and investor protections by ensuring that broker-dealers do not publish price quotes for a security when current information about that security is not publicly available.
Also, OTC trading is usually done through a licensed broker-dealer. Broker-dealers are regulated by the Financial Industry Regulatory Authority (FINRA).
What kinds of investments trade OTC?
Many OTC securities include stocks issued by small companies that don’t qualify to be listed on major exchanges because they don’t trade enough shares or their shares don’t sell above a minimum price. Often referred to as penny stocks, they trade for less than $5 per share.
Other OTC companies are larger, but can’t afford (or don’t want to pay) the listing fees the major exchanges charge. NASDAQ, for example, charges companies up to $163,000 to be listed, assuming they qualify.
Most bonds trade over-the-counter after their initial offering. OTC markets are a better fit for bonds than stock exchanges due to the large size of trades, number of bonds traded, and the infrequent trading of bonds.
Besides stocks and bonds, investments that trade OTC often include:
- Derivatives, private contracts between two parties, typically arranged by a broker. These can be options, forwards, futures, or other agreements whose value is based on that of an underlying asset, like a stock.
- American Depositary Receipts (ADRs), sometimes called ADSs, or bank certificates that represent a specified number of shares of a foreign stock.
- Foreign currencies. About $5 trillion worth in different nations’ money trades on what’s called the Forex, an over-the-counter currency exchange.
- Cryptocurrencies, like bitcoin and ethereum.
What are the major OTC markets?
There are two primary over-the-counter (OTC) networks, OTC Markets Group and Over-the-Counter Bulletin Board (OTCBB). As an investor, you have access to either or both of these markets depending on your broker.
OTC Markets Group
The majority of OTC trades take place on the OTC Markets Group, a private company. OTC Markets lists over-the-counter equities at three tiers, depending on their size, share price, and the amount of financial reporting and disclosure they do.
OTCQX is the highest tier – these are firms with audited financials that could trade on regular exchanges. The next, OTCQB, is for early-stage or growth companies; they must have a minimum bid price of $0.01.
The lowest tier is the most notorious: the Pink Market or “Pink Sheets.” These include foreign companies, penny stocks, shell companies, and other firms that choose not to disclose financial information.
Over-the-Counter Bulletin Board
The Over-the-Counter Bulletin Board (OTCBB) is hosted by the Financial Industry Regulatory Authority (FINRA), a non-governmental regulatory body. The OTCBB is a place for FINRA member broker-dealers to make offers to buy and sell equity of companies that report to the SEC, but are not listed on the major stock exchanges.
Only broker-dealers can trade on the OTC Markets Group and the OTCBB. The Grey Market, sometimes called Other OTC, is a catch-all category for any security that is considered over-the-counter but not quoted by broker-dealers due to a lack of investor interest, lack of financial information, or lack of regulatory compliance.
Is it safe to buy OTC stocks?
OTC trading has had a shady reputation. Partly that’s because of the basic way it operates. In contrast to the total transparency of the stock exchanges, where prices are displayed for all to see, OTC is a buyer and seller secretly negotiating a price. The seller might offer the stock to one buyer for one price and to another buyer for another.
Small wonder that OTC markets have been the site of scams and criminal activities. Dealing in penny stocks opens the door to illegal pump and dump schemes in which someone promotes (pumps) a stock, then sells (dumps) the stock after you and other investors buy, raising the price of the stock.
Bonus scams are also a major risk according to OTC Forex trader Frano Grgić, who notes the presence of unscrupulous “brokerages that want to lure beginners into trading by offering them large bonuses on their deposit.” Unfortunately, Grgić says, “when it comes time to withdraw funds, the money is gone.”
For regular investors, the only safe way to buy (or sell) OTC stocks is through a reputable broker-dealer using one of the two major online platforms, OTC Markets or OTCBB. They actually operate like “discount” stock exchanges, imposing some rules and oversight and, in OTC Markets’ case, classifying stocks into tiers.
Even then, consider the tier you plan to use and, of course, the reputation of the broker-dealer who will negotiate your trades.
Risks of OTC trading
Fraudulent activities aside, there are other risks associated with OTC trading.
- Lack of price transparency. As noted above, theoretically a seller could be charging a buyer one amount for a security, and naming another price to another.
- Low liquidity. Many OTC stocks are thinly traded, meaning there isn’t much demand. That can make them hard to sell when you want to.
- High volatility. Lower trading volume also leads to sharp price swings.
- Lack of oversight. OTC trading has less regulation than major exchanges’.
Benefits of OTC trading
Despite the drawbacks, OTC trading has its upsides too.
- The stars of tomorrow. Many big-name stocks started small, trading OTC. “Imagine buying shares of Twitter or Facebook in 2007,“ says Michael Bertov.
- Low transaction costs. Fees are lower on the OTC market compared to major exchanges, says Jon Ovadia, OTC trader and founder of the OVEX cryptocurrency exchange platform.
- Lower share prices mean your money goes farther and buys more of an OTC investment than an exchange-listed one.
- “Private and personalized service,” as Ovadia puts it – you’re dealing not in a huge, anonymous market space, but in a more intimate one, with an individual broker-dealer and the seller.
OTC trading is not for everyone. In fact, the SEC does issue this dire warning: “Academic studies find that OTC stocks tend to be highly illiquid; are frequent targets of alleged market manipulation; generate negative and volatile investment returns on average, and rarely grow into a large company or transition to listing on a stock exchange.”
If your investment strategy is ultra-conservative or if you are a relative novice, most experts suggest you stay away or at the very least, confine your trading to the OTCQX tier on OTC Markets Group.
On the other hand, “If you are able to be patient and disciplined, and are open to learning something new,” you may want to try OTC, says Grgić. He cautions, however, “If you do not have money to invest which you can lose,” don’t try it.