OTC Markets: What They Are And How They Work

Most people are familiar with the stock market, which is where investors and traders buy or sell shares of company stock. Stock market performance is frequently used as a measure of the overall health of the economy.

But there are other fairly active markets that far fewer people know about, much less engage in: Over-the-counter, or OTC, markets. These 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 stock market 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 — namely, that they could get first dibs on hidden gems. There are benefits for the stocks that are traded over the counter, too.

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.

Types of OTC securities

Assets traded on the over-the-counter markets include:

• Stocks.

• Bonds.

• Currencies.

• Derivatives, such as options, forwards and futures.

• Certificates of deposit.

• American depositary receipts, or ADRs, which are bank certificates that represent a specific number of shares of a foreign stock

Where the OTC Markets Group comes in

The OTC Markets Group is a tiered electronic system used by broker-dealers to publish prices for OTC securities. It is a common way for OTC securities to trade. The tiers of the OTC Markets Group include:

• The OTCQX Best Market

• The OTCQB Venture Market

• The OTCID Basic Market

• The Pink Limited Market

The OTC Markets Group has eligibility requirements that securities must meet if they want to be listed on its system for each tier, 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.

The quality of the investments — and specifically, the amount of information known about them and the requirements enforced — essentially goes in order. The Best Market (also known as OTCQX) is what it sounds like — the companies listed here are generally established, and they meet The OTC Markets Group's highest financial standards ^[0]

Penny stocks — which are sometimes called pink sheets — are known for being traded OTC. They aren't available through every brokerage account, are generally considered quite risky and, in addition to their OTC status, are often defined as stocks that trade for less than $5 per share. They are generally traded through the Pink Limited market.

“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,” Frederick 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?

How to buy 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. Here’s her step-by-step guidance:

1. Do your due diligence and find a broker that allows OTC trading, then research the industry or security you’re interested in. NerdWallet has a shortlist of the best brokers for OTC/penny stock trading.

2. 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.

3. 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, says Pickron.

4. 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 tiers the security falls into^[0]

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^[0]

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.

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."