OTC stocks, also colorfully known as “pink sheet stocks” due to the fact that they were once listed and distributed on sheets of pink paper, have a long and infamous history on Wall Street.
Some traders have famously made hundreds of millions of dollars trading the pink sheets—often using less than honest methods—and plenty of investors have lost their life savings.
This boom-or-bust mythology brings a lot of curious new investors and their money into the OTC markets, but it is imperative to understand the market and its risks before beginning to trade.
What are OTC Stocks?
Publicly-traded stocks can broadly be placed into two categories—those traded on major exchanges like NASDAQ or the New York Stock Exchange, and those traded over-the-counter (OTC).
In the most fundamental ways, OTC stocks are just like their cousins that are traded on major exchanges. They represent small pieces of ownership in a publicly-traded company and they can be bought or sold through most brokerages.
The biggest difference is in how well the companies are regulated. Companies trading on the NYSE or NASDAQ have very specific reporting requirements and have to hold themselves up to strict accounting standards. Companies trading over-the-counter have no such obligations.
This void of information leads to a lot of uncertainty and can make it very easy for scammers to create false news items or financial data in order to dupe other traders.
In response to a number of recent frauds, the Securities and Exchange Commission (SEC) has become much more active in regulating OTC markets and are now pushing even the smallest companies to disclose more financial data.
What Kinds of Companies Trade Over-the-Counter?
There’s a wide variety of companies that trade over-the-counter for a variety of reasons, but most of them fall into one of the following five categories.
Start-up companies often don’t have the financial history, balance sheet, or compliance to strict accounting requirements to qualify for listing on a major exchange. The over-the-counter market may represent the best option for such companies to raise capital.
Finding the start-ups amongst the OTC penny stocks that will one day go on to change the world (bringing you massive returns in the process) is the dream that pulls many starry-eyed traders into the OTC market. Finding such a diamond in the rough is extremely unlikely, but who can resist a longshot?
Most OTC companies are quite small, but there are some massive foreign conglomerates such as Nestle that trade over-the-counter in the US. These foreign companies simply want to avoid the substantial costs associated with meeting the accounting and disclosure requirements of being listed on one of the major stock exchanges.
Companies that were once listed on a major exchange but have been delisted for one reason or another find themselves at the mercy of the OTC marketplace. Often these companies are on the verge of bankruptcy and were delisted after their stock price fell below the minimum requirement. Some fully recover, but many fade into oblivion.
The OTC market also includes some established, successful small companies that for one reason or another haven’t scaled up their operations to the point of qualifying for a major exchange. Some of these don’t have significant growth avenues or aspirations and are content to trade as an OTC stock.
The OTC Markets Group has taken strides to purge illegitimate shell companies from their listings, but they are definitely still out there and to be avoided at all costs. A shell company is a company that is not actively operating as a business, but still may have assets. Often these companies are used for nefarious purposes such as pump and dump stock schemes.
Market for OTC Stocks
These days, almost all OTC stocks are traded through the OTC Markets Group. The improved organization and transparency provided by OTC Markets as well as increased interest by retail traders has led to an unprecedented boom in OTC trading. In the first nine months of 2021 alone, there has been more than $548 billion dollars in trading volume, already surpassing the record total of 2020.
OTC Markets Group lists more than 11,000 companies and organizes them into three risk-based categories in order to make things easier for investors.
The companies that fall into the OTCQX group are often large companies that are considered the least risky, most transparent companies on the OTC market. These are the companies that are often listed in other exchanges worldwide, so even though they don’t necessarily comply exactly with SEC reporting guidelines, they abide by generally accepted accounting principles and disclose financial information on a regular basis.
This is the category for the companies in the “entrepreneurial or development” stage that are still trading on the OTC market while they push for that big breakthrough. These companies are also fairly transparent but may not have a significant financial history. For a company to maintain the OTCQB designation, they must be certified every year through an auditing and management vetting process.
These are the old school pink sheet stocks. The OTC securities for which there is very little information available. The more opaque a company, the more risk, obviously, but the SEC and OTC Markets Group are pushing hard for these companies to provide more accurate financial information.
According to a new rule that took effect in September 2021, even penny stocks trading in the pink market must release their financials. Companies that do not comply can no longer be quoted by public broker dealers.
The effects of this new rule remain to be seen, but this could have a profound effect on anyone trading OTC stock.
Why Trade OTC Stocks?
The main appeal to trading in the OTC markets rather than the New York Stock Exchange or NASDAQ is pretty simple—higher upside.
The dramatic price swings that are typical of OTC markets and the penny stocks listed therein mean that someone is getting rich. Of course that often means substantial losses for someone else, but it’s human nature to “ac-cent-chu-ate the positive” as Bing Crosby once sang.
Capitalizing on the inherent volatility of many OTC stocks doesn’t have to be a boom or bust proposition, however. Experienced, disciplined OTC traders can mitigate their risk and still make solid returns by identifying big movers and getting in and out of their positions ahead of other traders.
Most OTC securities are also penny stocks, which present their own advantages, most notably in terms of affordability. Traders can take sizable positions in penny stock companies with relatively little cash, putting them in a prime position to capitalize on any news or price movements.
Although this is becoming less true as OTC securities grow in popularity, there is still the appeal of finding overlooked, undervalued companies that simply don’t exist on the major exchanges. There’s still a lot more eyeballs on the companies listed on a major stock exchange than on those selling over-the-counter. This means there’s a better chance of finding mispriced securities in over-the-counter markets.
Risks associated with the OTC market
As I’ve mentioned above, OTC stocks tend to be way more volatile than their cousins that are traded on major exchanges. That can present the opportunity for substantial profits, but the flip side is, of course, substantial losses if you make a bad trade.
The get-rich-quick potential is what lures a lot of traders into over-the-counter trading, but it can lead to poor trading discipline and losses.
Most stocks that trade OTC do so for a reason, be it inconsistent financial reporting, poor management, poor past performance, or simply a lack of verifiable information. There’s a lot more rough than diamonds.
OTC trading is also extremely susceptible to fraud. The most common example of market manipulation is the pump and dump scheme in which someone distributes a false news item about a stock they own. After the stock rockets up in reaction to the “news”, the fraudster sells their position before everyone catches on that the news item wasn’t true. Traders who were late to the party suffer substantial losses when the stock crashes.
Another of the biggest risks for those who buy OTC stocks is that they can be highly illiquid, which means you can become stuck in a position that you desperately want to get out of. For example, if you own a penny stock that starts to plummet due to bad news, demand might be so small that you might be unable to find a buyer and lose your entire investment.
Before you begin trading OTC stocks, make sure you understand the substantial risks and have a sound trading and investment strategy.
How to start trading OTC stocks
There’s no real trick to getting started trading OTC securities. Almost any online brokerage will allow you to trade over-the-counter.
Sometime in the near future I will be reviewing the best brokerages to handle your OTC transactions. In the meantime, keep these questions in mind as you make your choice.
- Do they trade OTC stocks?
All the major brokerages allow you to trade in the over-the-counter markets, but make sure it is permitted in your specific account. Keep in mind the new rules about broker dealers no longer being allowed to provide quotes for companies that don’t make financial disclosures. If you already have specific OTC companies in mind that you’d like to buy or sell, make sure they are not unlisted stocks and that your brokerage can provide a quote.
You’ll see a lot of advertising these days about brokerages that charge zero commissions. That may be true when dealing with the major stock exchanges, but most brokerages still charge commissions when it comes to OTC stocks. Make sure you know exactly how much you’ll be paying per trade.
- Trading platforms
Check out your prospective new brokerage’s trading platform before you commit. Make sure the layout is user friendly and that you can easily make transactions. OTC markets move fast, so you don’t want to be fumbling around when it’s time for you to execute a trade.
- Trader support
Make sure you sign up with a brokerage that has a solid customer service team who can walk you through any technical issues you may have. Some brokerages also offer access to great resources in terms of market research and educational materials. Knowledge is invaluable. See how well your potential brokerage covers the OTC markets and how they can help you learn.
If you are going with one of the large, trusted names, this isn’t an issue, but if you are being solicited by a new, unfamiliar brokerage, make sure they are registered with the Financial Industry Regulatory Authority.