Over-the-counter stocks are not traded on a public exchange like the New York Stock Exchange (NYSE) or Nasdaq. Instead, these stocks are traded through a broker-dealer network.
In addition to stocks, the over-the-counter (OTC) market can also include other types of securities. The Financial Industry Regulatory Authority regulates broker-dealers that engage in OTC trading.
What is an OTC stock, exactly? There are different reasons why a stock or other security may trade over the counter rather than being listed on a public exchange. Trading OTC stocks can be rewarding, but also potentially risky for investors.
Before dipping into the OTC market, it’s important to understand the meaning of OTC stocks, and where these securities might fit into your portfolio.
What is OTC Stock?
In order to grasp OTC stock trading and how it works, it helps to have a clear understanding of public stock exchanges.
A stock exchange — like NYSE or Nasdaq — is a regulated environment in which buyers and sellers can trade shares of publicly listed companies. Before a stock can be listed on an exchange for public trading, it first has to meet the guidelines established by that exchange (for example, a company that wants to be listed on the Nasdaq must meet the Nasdaq listing requirements).
Companies may opt to trade shares in the over-the-counter market (meaning, they trade through a broker-dealer) if they’re unable to meet the listing requirements of a public exchange. OTC trading may also appeal to companies that were previously traded on an exchange but have since been delisted.
Recommended: What Are Stock Delistings and Why Do They Occur?
Also, stocks that are traded on an exchange are called listed stocks; those that trade OTC are often called unlisted stocks.
What Kind of Securities Trade on the Over-the-Counter Market?
OTC trading tends to focus on equities, i.e. stocks. In fact, it’s even common to see penny stocks being traded over the counter. The Securities and Exchange Commission (SEC) generally defines penny stocks as stocks that trade for less than $5 per share. Penny stocks can also be referred to as micro-cap stocks. A micro-cap stock has a market capitalization of less than $250 million or $300 million, versus $10 billion or more for large-cap stocks. (Market capitalization is a measure of valuation, based on the number of shares outstanding multiplied by the share price.)
But stocks don’t make up the entirety of OTC trading activity. Other types of investments that can be traded OTC include:
• Corporate bonds
• Government securities
Cryptocurrency can also be traded over the counter. Over-the-counter crypto trading has gained popularity because it offers traders liquidity as well as anonymity.
Recommended: What is Cryptocurrency? The Fundamentals of Crypto
Altogether, there are an estimated 10,000-plus securities that trade on the over-the-counter market. These can include small and micro-cap companies, large-cap American Depositary Receipts (ADRs), and foreign ordinaries (international stocks that are not available on US exchanges). Companies that trade over the counter may report to the SEC, though not all of them do.
So Where Are OTC Securities Traded, Exactly?
In the US, the majority of over-the-counter trading takes place on networks operated by OTC Markets Group. This company runs the largest OTC trading marketplace and quote system in the country (the other is the OTC Bulletin Board or OTCBB). While companies that trade their stocks on major exchanges must formally apply and meet listing standards, companies quoted on the OTCBB or OTC Markets do not have to apply for listing or meet any minimum financial standards.
OTC Markets Group organizes OTC stocks and securities into three distinct markets:
• Pink Sheets
OTCQX is the first and highest tier and is reserved for companies that provide the most detail to OTC Markets Group for listing. Companies listed here must be up-to-date with regard to regulatory disclosure requirements and maintain accurate financial records. Penny stocks, shell corporations, and companies that are engaged in a bankruptcy filing are excluded from this grouping. It’s common to find stocks from foreign companies (e.g. foreign ordinaries) listed here.
The middle tier is designed for companies that are still in the early to middle stages of growth and development. These companies must have audited financials and meet a minimum bid price of $0.01. They must also be up-to-date on current regulatory reporting requirements and not be in bankruptcy.
The Pink Sheets or Pink Open Market has no minimum financial standard that companies are required to meet, nor do they have reporting or SEC registration requirements. These are only required if the company is listed on a Qualified Foreign Exchange. Be forewarned: OTC Markets Group specifies that the Pink Market is designed for professional and sophisticated investors who have a high risk tolerance for trading companies about which little information is available.
Pros and Cons of OTC Trading
Investing can be risky in general, but the risks may be heightened with trading OTC stocks. But trading higher risk stocks could result in bigger rewards if they’re able to produce above-average returns.
When considering OTC stocks, it’s important to understand how the positives and potential negatives may balance out. It’s also helpful to consider your personal risk tolerance and investment goals to determine whether it makes sense to join the over-the-counter market.
|OTC Stock Trading Pros||OTC Stock Trading Cons|
|Over-the-counter trading may be suitable for investors who are interested in early stage companies that have yet to go public via an IPO.||Micro-cap stocks and nano-cap stocks that trade over the counter may lack a demonstrated track record of positive performance.|
|Investing in penny stocks can allow you to take larger positions in companies.||Taking a larger position in a penny stock could amplify losses if its price declines.|
|May appeal to active traders who are more interested in current pricing trends than fundamentals.||Limited information can make it difficult to assess a company’s financials and accurately estimate its value.|
|Trading cryptocurrency on an OTC exchange could help minimize hacking or security risks.||OTC securities are subject to less regulation than stocks listed on a public exchange, which may increase the possibility of fraudulent activity.|
|OTC trading makes it possible to invest in foreign companies or companies that may be excluded from being listed on a public exchange.||OTC stocks may be more illiquid than stocks traded on a public exchange, making it more difficult to change your position.|
Why would you want to trade stocks over the counter? Since OTC stocks trade outside of traditional exchanges like the NYSE or Nasdaq, the OTC market gives you access to different types of securities, including penny stocks, international stocks, derivatives, corporate bonds, and even cryptocurrency. If you’re interested in OTC trading, the first step is to consider how much risk you’re willing to take on and how much money you’re willing to invest. Having a baseline for both can help you to manage risk and minimize your potential for losses.
Either way, you can still get started by investing online. With SoFi Invest, for example, you can trade stocks, ETFs, and cryptocurrency. SoFi members also have access to IPO trading, if you’d like to invest in up-and-coming companies as they go public. It’s easy to get started with SoFi Invest and trade with minimal fees.
Photo credit: iStock/JohnnyGreig
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