Over-the-counter (OTC) stocks (also known as unlisted stocks) trade differently from stocks that are listed on a major stock exchange. This article will take a closer look at what makes OTC stocks different from listed stocks and what types of securities trade on OTC markets. It will also review the three tiers of OTC stocks as well as the benefits and risks of owning OTC stocks.
When you finish reading this article, you should be able to define:
- How an OTC stock is different from a stock that is listed on a major, centralized stock exchange such as the New York Stock Exchange or NASDAQ
- What are some common types of securities that trade on OTC markets?
- What are the benefits and risks of owning OTC stocks?
What Are Over-the-Counter (OTC) Stocks?
Over-the counter (OTC) stocks are publicly traded stocks that, for one or for a number of reasons, are not listed on a major stock exchange such as the New York Stock Exchange (NYSE) or the NASDAQ. OTC stocks are traded between two parties instead of in a publicly traded market.
OTC stocks require a dealer-broker (i.e. a middleman) to facilitate transactions as opposed to a public exchange that uses an auction system that is largely electronic.
Over-the-counter stocks carry significantly higher risk than stocks that are traded on a public exchange. This is primarily due to a lack of a formal governing institution. OTC stocks generally have to meet some guidelines but do not have nearly the stringent requirements of stocks that trade on the NYSE or NASDAQ.
For example, in September 2020, the SEC published updated its regulations for the OTC markets to ensure that a broker-dealer could not publish a price quote for an OTC security when current information about that security is not available to the general public.
What Types of Securities Trade in the OTC Markets?
An estimated 10,000 securities trade through the OTC Markets Group. The most commonly traded security in the OTC markets is stocks. Specifically, the OTC market features small-cap stocks (i.e. stocks of companies with a market cap of less than $2 billion) that don’t qualify to be listed on a major exchange. Foreign stocks tend to make it onto OTC markets.
The reasons why a stock may not be traded on a major exchange include:
- The company doesn’t trade a high enough volume of shares.
- The company cannot meet the exchange’s minimum price requirement (typically $1).
- They are penny stocks which are defined as stocks that trade for $5 or less.
The OTC market is larger than many investors may think. In addition to stocks, most bonds will trade in the OTC market after their initial offering. This is due to the large size of trades, the number of bonds trade and the fact that, unlike stocks, bond trading is relatively infrequent.
The OTC market is also where many derivatives are traded. Derivatives are private contracts between two parties these include options, futures, forwards where the value of the contract is based on its underlying asset.
Additional securities traded in the OTC markets include American Depositary Receipts (ADRs) and foreign currencies (Forex). In fact, more than $6.5 trillion is traded on the OTC Forex currency exchange.
The Three Tiers of OTC Stocks
OTC stocks are sometimes referred to as Pink Sheet stocks. In fact, the OTC Markets Group, the publicly traded company that provides liquidity for nearly 10,000 OTC securities, was previously known simply as Pink Sheets. Nearly all OTC trades take place on the OTC Markets Group.
There is another OTC Market, the Grey Market that is reserved for over-the-counter securities that are not quoted by broker-dealers for several reasons including lack of investor interest, lack of financial information, or a lack of regulatory compliance. For the purposes of this article, we are talking about securities that trade on the OTC Markets Group.
There are three different tiers of OTC stocks within the OTC Markets Group: the OTCQX, the OTCQB, and the Pink Sheets. Equities fit into a category based on its size, share price and the amount of financial reporting and disclosure it does.
Here is a brief description of each tier with its eligibility requirements.
OTCQX – this is the premium tier of OTC stocks. However, only about 4% of the stocks on the OTC market fall into this category. One reason for that is that this tier does not include penny stocks. These companies provide a lot of detail to the OTC Markets Group including audited financials. In fact, being up-to-date with regulatory disclosure requirements is a prerequisite for a stock to be listed on this exchange.
OTCQB Venture Market – this marketplace is for early-stage companies that are in their initial growth stages. These companies require a bid price of at least $0.01 and cannot be in bankruptcy. Additionally, the company must have a freely traded public float of at least 5% or a separate class of securities that are traded on a national exchange. These companies also provide audited financials.
Pink Open Market – the lowest tier is the default market for broker-dealers who want to trade securities on the OTC market. This tier includes companies that do not wish to disclose financial information. This is true of some foreign companies, penny stocks, and shell companies.
What are the Risks of Owning OTC Stocks?
OTC stocks are sometimes referred to as “for sale by owner” stocks. You could also go with “let the buyer beware.”
That’s because one of the largest risks to owning and trading OTC stocks is that of fraud. Unlike on a major stock exchange, there is no price transparency for OTC stocks. The price a security trades for is a direct result of a negotiation between a buyer and a seller. This means a seller could offer one buyer stock at X price while simultaneously offering the same stock to another buyer at Y price.
Some of this risk is taken away if you’re trading on the OTC Markets using a reputable broker-dealer. However, some concerns remain for example:
- OTC stocks are less liquid – One of the advantages of a stock that trades on a major exchange is an investor’s ability to trade the stock when they want at the price they want (give or take a penny or two). That’s not the case with OTC stocks which have less demand. That can make them difficult to trade when you want to do so.
- OTC stocks have more volatility – A byproduct of low liquidity, OTC stocks may have sharper price swings due to lower trading volume.
- OTC stocks are not required to have stringent oversight – Although some companies will provide audited financials, it is not a requirement for stocks in the Pink Open Market where many of the penny stocks are found.
What are the Benefits of Owning OTC Stocks?
Although they do carry an outsized risk, there are a couple of benefits for investors looking to own over-the-counter stocks.
- Getting in on the Ground Floor – In many cases, these companies are truly start-up companies. This gives investors the chance to invest in these companies before they become widely known.
- A Little Goes a Long Way – Many of these stocks are penny stocks (i.e. they trade for less than five dollars). That means that investors can take a large position in the company for a relatively small investment.
- Ideal for Active Traders – One of the advantages of OTC stocks for active traders is that they are not concerned with a company’s fundamentals and are only seeking to profit from price action.
Additional benefits include a lower fee structure and more personalized service since investors are only dealing with a broker-dealer and a seller.
Some Final Thoughts on OTC Stocks
If it’s not crystal clear at this point, it needs to be said that trading OTC stocks in not for novice and/or conservative investors with a low risk tolerance. There is a chance that investors can lose all of their principal in taking on the risk that comes from OTC stocks.
With that said, OTC stocks wouldn’t exist if there wasn’t a market and an appetite for them. Active traders may find that OTC stocks give them the price action they can’t get from a central exchange. And because they’re trading stocks that are overlooked by the broader market, they are investing in stocks that aren’t drawing attention from institutional investors.
