The OTC markets: A beginner’s guide to over-the-counter trading

While the New York Stock Exchange (NYSE) and the Nasdaq get all the press, over the counter markets, or OTC markets, list more than 11,000 securities across the globe for investors to trade. 

OTC markets offer the chance to find hidden gems, but also the potential to wind up stuck in a scam stock that you are unable to sell before it becomes worthless. But for investors willing to do the legwork, the OTC markets offer opportunities beyond the big exchanges.

Here’s what the OTC markets are, what you can trade there and why companies trade over the counter.

What are the OTC markets?

The OTC, or over the counter, markets are a series of broker-dealer networks that facilitate the exchange of various types of financial securities. They differ in several key aspects from the stock exchanges that most investors and the broader public know of.

Investors are familiar with trading on an exchange such as the NYSE or Nasdaq, with regular financial reports and relatively liquid shares that can be bought and sold. On an exchange, market makers – that is, big trading firms – help keep the liquidity high so that investors and traders can move in and out of stocks. Exchanges also have certain standards (financial, for example) that a company must meet to keep its stock listed on the exchange.

In contrast, the OTC markets consist of broker-dealers at investment banks and other institutions that phone around to other brokers when a trader places an order. These brokers look for buyers or sellers willing to take the other side of the trade, and they may not find one. Therefore, securities on OTC markets are typically much less liquid than those on exchanges. Because of this structure, stocks may not trade for months at a time and may be subject to wide spreads between the buyer’s bid price and the seller’s ask price (i.e., wide bid-ask spreads).

But OTC markets offer the ability for large and small – indeed, tiny – stocks and other securities to be listed with different requirements and, in some cases, no requirements at all.

The OTC markets consist of several sub-markets with various features and requirements:

• OTC Link – OTC Link handles stocks, some corporate debt securities and foreign securities. It has three sub-marketplaces, with varying listing requirements:
• OTCQB: This marketplace includes securities of companies that are up to date in their financial reporting to the SEC or an appropriate regulator.
• OTCQX: This marketplace includes securities of companies that are current in their reporting to the SEC or the appropriate regulator, or if not required to report to the SEC, are up to date in their filings to OTC Link. They should have audited financial statements and meet certain eligibility requirements.
• OTC Pink: Also known as the pink sheets, OTC Pink is more like the Wild West, with no financial standards and no requirement that companies report to the SEC.

Because financial statements and other disclosures are vital to investors, investors should know if their OTC security is required to file statements and should be cautious if it’s not mandated to do so.

What investments can you trade OTC?

You can trade a surprising number of securities on the OTC market, including:

• Stocks: Many publicly traded companies trade over the counter instead of through a major exchange.
• ADRs: ADR, or American Depositary Receipt, is a fancy term for foreign companies whose stocks may trade over the counter (or on the major exchanges) in the U.S. Many reputable companies trade over the counter as ADRs, including BMW and Nestle.
• Bonds: Corporate bonds typically trade over the counter.
• Derivatives: Derivatives such as options or swaptions may also trade over the counter, which is typical for non-standard contracts.
• Penny stocks: The OTC market is also a popular place for suspect penny stocks, many of which offer low stock prices and even lower liquidity.

The OTC market allows many types of securities to trade that might not usually have enough volume to list on an exchange. This feature gives investors access to more securities.

Why do companies trade OTC?

Companies may trade over the counter for a variety of reasons, so investors should understand the drawbacks and risks associated with trading OTC.

Some major reasons to list on the OTC markets include:

• Lower listing requirements than a major exchange. The major exchanges have higher listing requirements that some companies can’t or don’t want to meet. These include a certain number of outstanding shares, a minimum market capitalization, a minimum share price, a certain level of financial strength and financial reporting.
• Cheaper than a major exchange. Trading on a major exchange can easily cost a company more than $100,000 annually, and for small companies that fee can eat up a significant portion of their profits. The OTC market is cheaper.
• Easier for foreign companies. Some foreign companies can’t or don’t want to list on a major exchange because of the added expense and requirements. So, listing on the OTC markets requires less of them while still allowing them to reach American investors.
• May not be required to file with the SEC. On some OTC markets such as the pink sheets, it’s not a requirement to file financial reports with the SEC, meaning investors should beware.

Those are some of the key reasons that a company might file to list its stock over the counter.

Bottom line

The OTC market might hold a lot of attractive stocks, but it certainly contains stocks of many less attractive companies that may be difficult to sell after you acquire them. Investors who are transacting over the counter should carefully understand the risks associated with trading there and the stocks that call it home. Unfortunately, it can be buyer beware on OTC markets.