Over-the-counter (OTC) refers to buying and selling securities outside of an official stock exchange. The OTC markets have become a popular hunting ground with savvy investors, day traders and retail investors who are looking to invest in companies with exponential growth potential.
Little-known companies offering significant upside potential and untapped value are the order of the day, and the OTC markets are where start-ups and newly public companies are just getting noticed.
However, buying stocks OTC is different from buying stocks on the NASDAQ or NYSE. Read on to understand how to buy OTC stocks, and to find out if investing in the OTC market is the right investment choice for you.
What are the OTC markets?
The OTC market is an electronic network of buying and selling activity made of securities that are not listed on a major exchange such as the NASDAQ or NYSE.
On the OTC, two parties trade investments with each other using a dealer-broker as an intermediary. This differs from centralized exchange-traded stocks, which are auction-driven.
OTC investments cover the spectrum of penny stocks, derivatives, bonds, American Depository Receipts (ADRs), and currencies.
Most companies who list OTC are too small to list on major exchanges, so the companies opt for the OTC market instead. The types of companies you will find on the OTC markets include start-ups, emerging growth stocks, and foreign companies. Indeed, the full spectrum of industry sectors and business ideas can be invested in via over-the-counter stocks. These also include companies often called ‘penny stocks’ because they trade for under $5 a share.
Companies that trade on the OTC markets are public but unlisted. This means that you can buy and sell shares in the business, but the stock does not appear on a major exchange. This is necessary for those investments that don’t meet the stringent requirements of listing on recognized exchanges.
Buying and selling stocks over the counter differs from trading shares on the New York Stock Exchange (NYSE), NASDAQ and other well-known exchanges because these companies are much smaller. There is also less liquidity for OTC securities compared to major exchanges because there are fewer buyers and sellers, and because of this, OTC investing carries more risk.
However, there are some protections for potential investors, as most OTC stocks are covered by Financial Industry Regulatory Authority (FINRA) oversight, a government-authorized organization that oversees the financial markets.
How does the NMS relate to the OTC?
The National Market System (NMS) governs all equity trading undertaken on formal US stock exchanges and the NASDAQ market. In contrast, OTC trades are not traded on an NMS exchange.
A stock must meet size, profitability, and trading activity criteria to be eligible to trade on an NMS exchange. This is not necessary for OTC stocks which is why they carry more risk.
Equity trade information such as high, low and last-sale price, cumulative volume figures, and bid and ask quotations throughout the day are not always available for OTC stocks. That’s because market makers are not obligated to report price and share transaction size in real-time.
What is the OTC Markets Group?
OTC Markets Group, Inc. engages in the provision of trading, corporate, and market data services. The firm operates through the following business lines: OTC Link, Market Data Licensing and Corporate Services.
The OTC Link provides trading services to FINRA member broker-dealer subscribers.
Market Data Licensing provides market data and compliance data for a wide spectrum of securities and companies.
Corporate Services operates the OTCQX and OTCQB markets and offers issuers disclosure and regulatory compliance products.
The OTC Markets Group was founded in 1904 and is headquartered in New York.
Types of OTC Tiers
OTC Markets Group is an American financial marketplace providing price and liquidity information for over 11k over-the-counter securities.
Although the OTC market is often thought of as one market, it is actually made of three separate exchanges:
OTCQX: The OTCQX is the ‘top-tier’, and indeed the OTC Markets Group website describes it as ‘The Best Market.’ Here you will find businesses with large market caps, high liquidity and solid backing. The stocks listed on the OTCQX are established, investor-focused US and international companies. Some of these foreign companies already have a primary listing on a qualified international stock exchange and desire a presence on the US market.
OTCQB: The OTC Markets Group describes the OTCQB as ‘The Venture Market’, and this can be thought of as the ‘mid-tier’, giving investors access to US and international companies at the entrepreneurial and development stages. These companies on the OTCQB must be up-to-date with their reporting - which means they have filed all relevant reports and financial statements with the SEC or relevant regulator. They are also duty-bound to an annual verification and management certification process. The stock must meet a $0.01 bid test and may not be in bankruptcy. The bid test means the company must have registered priced quotations published by a market maker in OTC Link ATS with a closing bid price of at least $0.01 for 30 days before application and on the date of approval. Foreign companies that have not had any public US trading activity can submit a FINRA approved form confirming they’ve traded on a Qualified Foreign Exchange at a price equal to or greater than $0.01 to apply for an exemption.
Pink Market: The OTC Pink Market, also known as the “pink sheets,” is the bottom tier of the OTC Market Group offerings and has the least stringent acceptance rules. The pink sheets marketplace offers investors a vast range of equities to trade, some of which may be in default or financial distress. This is the riskiest of all OTC marketplace tiers as it doesn’t have disclosure requirements, so the available data comes straight from the company.
Grey Market: There is a fourth catch-all category for OTC trades known as ‘the grey market’ or Other OTC. Broker-dealer's trade on the OTC Markets Group, but if an equity does not have enough investor interest or too little financial information, the broker-dealer may choose not to quote it. These OTC stocks then fall through the OTC Market Group tiers into the Other OTC or grey market.
The grey market is not regulated, is difficult to access and should be avoided by beginners to stock market investing. In fact, very few people choose to trade grey market stocks.
Pros and Cons of Investing in OTC Stocks
Investing in the OTC market is an attractive way to take a shot at achieving exponential gains. It gives start-ups access to public money and investors an opportunity to own a piece of an exciting business.
Like any investment, OTC stocks have advantages and disadvantages over investing in major stock exchanges.
Pros of OTC investing
Lower Costs: With fewer rules and regulations than centralized exchanges, the OTC is a competitive space. Market makers are constantly vying for volume, so transaction costs are pushed down.
Access to Interesting Equities: OTC stocks are hugely varied and interesting, covering companies from all sectors and industries. It also gives you access to many foreign country equities and investments.
Big Stake Opportunity: As OTC companies are usually small and trading at low rates, you can obtain a significant equity stake for your investment.
Big-names started small: Getting in early is the key to making significant gains. Many OTC stocks are high-growth companies with exponential potential.
Cons of OTC investing
Lack of Liquidity: The biggest downside to trading OTC is the lack of liquidity. A dealer can withdraw from their position at any time. If they’re no longer there to buy, you are left holding a stock that is impossible to sell or selling at a much lower price than you’d like.
Transaction Transparency: You may not see real-time bid and offer prices or foreign exchange fees. The broker-dealer acts as the market maker, and transparency is at the broker’s discretion.
Information Inequality: The bid and offers are not always fairly distributed. The broker may quote different prices to their clients, individual customers, and other dealers.
How to Purchase OTC Stocks
If you would like to purchase shares in an OTC-listed company, here are the steps to follow:
Understand Your OTC Market Tier
OTC stocks are listed under three different marketplaces - the OTCQX, the OTCQB and the Pink Market. These are tiered by quality and each market has different types of companies, so make sure you fully understand the potential risks and rewards of companies within each tier before starting to invest.
Fix Your Budget
An OTC investment is high-risk, and you shouldn’t invest what you can’t afford to lose. Treat this as a speculative outlay. Size your position carefully in a diversified portfolio.
Choose Your Broker-Dealer
You don’t have to go hunting for a shady backroom dealer. Many well-known brokerage firms offer OTC trading. You may find your usual broker offers the stock you want, or you can shop around. Comparing fees to get the best value for money on your deal is wise. OTC fees do tend to vary in comparison to regular stock trading.
Fund your account
Check your broker will allow you to trade the OTC stock you are interested in. Then you can fund your account.
Ask for help
Executing the OTC trade may differ slightly from broker to broker. Depending on liquidity, buying an OTC stock sometimes requires help. Your broker’s customer service desk should be able to help you
Buy your OTC stock
Just like buying traditional stocks, you’ll have the option for market or limit orders when you place the trade. Your broker-dealer can sometimes fill the order internally if there is enough interest in the stock. Alternatively, the quote will be sent to the OTC market to trade among other broker-dealers. A lack of liquidity will widen the spread between the bid and ask price. In the event of very little interest, the broker-dealer may change the existing quote to match an available price or position size.
Investing in OTC Stocks
Buying and trading stocks on OTC markets is not for everyone. These stocks are less liquid (which means fewer people are buying and selling) and carry more risk than equities traded on well-known exchanges. The OTC markets are notoriously speculative, and you can quickly lose your money without careful planning.
On the OTC Markets, investors have access to data on 11,000+ securities through multiple channels, including Bloomberg, REDI Technologies and Thomson Reuters. This makes it an interesting and exciting place to trade and seek your fortune.
Many successful stock pickers have found OTC stocks to be a lucrative addition to a highly diversified portfolio. But they are high-risk investments and, as such, should not be the sole make-up of your portfolio.
Despite OTC market rules being less stringent than the big exchanges, the SEC still has a degree of oversight. In September 2020, SEC regulations were updated to enhance disclosure and investor protections.
Plus, buying and selling OTC shares is done through a licensed broker-dealer, which FINRA regulates.
Trading your cash on the OTC markets can be akin to gambling; therefore, limiting your stock search to the OTCQX and OTCQB is sensible, particularly for beginners.
Nevertheless, OTC Market trading is cheaper to access, and the rewards can be game-changing. This marketplace provides early access to high-growth emerging companies with massive upside potential.