Most stocks trade on a major stock exchange, like the Nasdaq or the New York Stock Exchange. But some securities trade on decentralized marketplaces known as over-the-counter (OTC) markets. There are a number of reasons a stock may trade on OTC markets, but often it’s because the company can’t meet the stringent requirements of a major exchange. Learn how OTC trading works and what you should know before investing in OTC securities.
What is OTC?
What is OTC?
OTC stands for over-the-counter. Over-the-counter trading is the buying and selling of securities that aren’t listed on a major stock exchange. OTC trading takes place through decentralized exchanges consisting of broker-dealers that facilitate transactions. Some types of securities that often trade OTC include:
- Penny stocks, generally defined as those priced at less than $5 per share
- International stocks and American depository receipts (ADR), which are certificates that represent a specific number of shares of a foreign company
- Stocks that have been delisted because the company is in bankruptcy or no longer meets the requirements of a major exchange
- Bonds
- Financial derivatives, like forwards and swaps
In practice, buying and selling OTC securities may not feel much different than buying and selling securities that trade on a major exchange due to electronic trading. Also, you can trade many OTC securities using most mainstream brokerage accounts. But OTC networks lack the rigorous financial reporting and transparency standards of major stock exchanges, so extra caution and due diligence is required from investors.
OTC Markets Group (OTCM 0.52%) is a publicly traded company that provides an open market for about 12,000 OTC securities. The company has three different exchanges:
- OTCQX Best Market: This exchange is considered the top tier for OTC securities. It has the strictest transparency standards, requiring annual audited financials and timely disclosure of material news. Penny stocks, companies in bankruptcy, shell companies, and blank-check companies are ineligible for inclusion.
- OTCQB Venture Market: This exchange is reserved for early-stage companies with a minimum bid of $0.01. Although the reporting standards are less stringent compared to the Best Market, companies must provide annual audited financials and current reports to a U.S. regulator, such as the Securities and Exchange Commission (SEC). Companies in bankruptcy are prohibited.
- Pink Sheets: Pink Sheets securities have scant reporting requirements, no minimum financial standards and are generally considered the riskiest of the three exchanges.
Over-the-counter securities that don’t trade through OTC Markets Group are known as grey market securities. These markets are unregulated, and broker-dealers don’t quote their prices.
Risks and rewards
Risks and rewards of OTC trading
Not all OTC securities are bad investments. For example, many hugely profitable global companies that are listed on foreign exchanges trade OTC in the U.S. to avoid the additional regulatory requirements of trading on a major U.S. stock exchange. Buying stocks through OTC markets can also provide the opportunity to invest in a promising early-stage company. Some companies may want to avoid the expense of listing through the NYSE or Nasdaq.
One of the big risks, though, is that OTC securities tend to be thinly traded. As a result, they often lack liquidity, which means you may not be able to find a willing buyer if you want to sell your shares. Low trading volume can create enormous price volatility. Because supply and demand may be out of sync, you’ll often find wide bid/ask spreads for OTC securities.
Because the disclosure requirements are lax and the financial standards are sometimes non-existent, you may find companies with no proven track record or that have been delisted from major exchanges due to bankruptcy or other financial trouble. The lack of transparency can leave OTC investors vulnerable to fraud. In a pump-and-dump scheme, for example, fraudsters spread false hype about a company to pump up its share prices, then offload them on unsuspecting investors.
Examples
Examples of OTC securities
Swiss food and drink company Nestle (NSRGY 1.78%) is an example of a major company that trades OTC in the U.S. The company has a $300 billion and a long history of dividends. While it’s listed on the SIX Swiss Stock Exchange, the company’s shares are only available as ADRs through the Pink Sheets in the U.S.
For an example of a troubled company that trades OTC, look to Revlon. The cosmetics giant was delisted from the NYSE in October, four months after filing for Chapter 11 bankruptcy. Revlon had appealed its delisting; shares plummeted more than 50% after the NYSE denied its appeal. It now trades as a Pink Sheets stock under the ticker symbol (OTCMKTS : REVRQ), with the “Q” indicating that the company is in bankruptcy.
