OTC Markets: What They Are And How They Work
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What is an over-the-counter market?
Over-the-counter, or OTC, markets are decentralized financial markets where two parties trade financial instruments using a broker-dealer. Among assets traded in the over-the-counter market are unlisted stocks. When a company is unlisted, it is public and can sell stocks, just not on a security exchange such as Nasdaq or the New York Stock Exchange.
“The OTC market is essentially just a lower-tier marketplace for smaller companies that trade less often, don't make as much, their prices are lower, [and] their volumes are typically lower,” says Randy Frederick, managing director of trading and derivatives at Schwab Center for Financial Research based in Austin, Texas.
Sound risky? It can be, but some investors see the potential upside — they could get first dibs on hidden gems.
How OTC markets work
Let’s say a small company wants to sell its stock but doesn’t meet the prerequisites of an exchange, such as reaching a minimum share price or having a certain number of shareholders.
Or maybe the company can’t afford or doesn't want to pay the listing fees of major exchanges. Whatever the case, the company could sell its stock on the over-the-counter market instead, and it would be selling "unlisted stock" or OTC securities. Basically, it's selling stock that isn’t listed on a major security exchange.
What is the OTC Markets Group?
OTC securities can trade via alternative trading systems such as the OTC Markets Group, a tiered electronic system used by broker-dealers to publish prices for OTC securities.
The three tiers of the OTC Markets Group include:
The Best Market.
The Venture Market.
The Open (Pink) Market.
The OTC Markets Group has eligibility requirements that securities must meet if they want to be listed on its system, similar to security exchanges. For instance, to be listed on the Best Market or the Venture Market, companies have to provide certain financial information, and disclosures must be current.
Frederick explains how these tiers work and the level of risk at each.
“The top tier of the OTC market is pretty safe and chances are pretty good. The requirements are there's enough known about a company that is probably not too risky,” he says.
“Once you get down to the very bottom level, the pink sheets, then there's obviously a lot of risk there because not only do you have the stock potentially like a penny stock — very, very cheap — but because of the minimum requirements for disclosures and reporting. There's a possibility that there could be fraud at the very lowest level of the pink sheet market,” he says.
This tiered marketplace can be used as a benchmark or guide for investors so they’re aware of how much risk they're taking.
» Dive deeper: What are penny stocks?
Buying securities on the OTC markets
Buying OTC securities is pretty straightforward because they trade like most other stocks, said Romy Pickron, a certified financial planner located in Dallas, in an email interview. Here’s her step-by-step guidance:
Do your due diligence and find a broker that allows OTC trading, then research the industry or security you’re interested in.
Find the ticker symbol for the security. Contact your broker directly if you cannot find the information you are seeking. As a buyer and seller of OTC securities, you may have to obtain an additional level of approval prior to trading from your broker-dealer due to the higher level of risk associated with these securities.
Determine how much you want to invest. OTC markets are most suitable for investors who are comfortable with risk, and/or interested in diversifying their portfolios through access to foreign markets, said Pickron, who’s also the CEO of Asset Achievers, based in Dallas.
Purchase your OTC security through a broker. Consider placing a limit order, due to the possibility of lower liquidity and wider spreads. Lower liquidity means the market may have fewer shares available to buy or sell, making the asset more difficult to trade. When there is a wider spread, there is a greater price difference between the highest offered purchase price (bid) and the lowest offered sale price (ask). Placing a limit order gives the trader more control over the execution price.
» Learn more: What is a broker and why do I need one?
Before purchasing an OTC security, you can use the OTC Market Group website to see which of the three tiers the security falls into.
OTC markets vs. exchanges
The main difference between OTC markets and exchanges is that exchanges are centralized, they publicly list stock prices and have government oversight. OTC markets are decentralized, they are networks of trading relationships centered around broker-dealers, and have less regulation. This means OTC markets can be riskier and more prone to fraud.
Another notable difference between the two is that on an exchange, supply and demand determine the price of the assets. In OTC markets, the broker-dealer determines the security’s price, which means less transparency.
Usually, a trader has the OTC security, then it goes to a broker-dealer, and then the broker-dealer trades it to the person who's buying it. The security’s price isn’t listed publicly as it would be on an exchange regulated by the Securities and Exchange Commission, says Brianne Soscia, a CFP from Wealth Consulting Group based in Las Vegas.
“Because there's less regulation, they're known to be targets of market manipulation where prices can be manipulated. It involves a lot of risk because you're buying typically less reputable securities. So there's always the potential for negative returns,” she says.
Types of OTC securities
Assets traded on the over-the-counter markets include:
Stocks, including penny stocks, which typically trade for less than $5 per share.
American depositary receipts, or ADRs, which are bank certificates that represent a specific number of shares of a foreign stock.
Ready to take the plunge? Before you do, think about the pros and cons.
There are benefits of OTC securities, but consider the risks involved, and decide whether they align with your financial goals. OTC markets provide opportunities for bigger moves, but because of reduced regulation, the reverse could also happen, Soscia says.
“It may be easier to double your money faster, but that can also be a con because it would be easier to lose all your money faster as well."