Securities that trade “over-the-counter,” or OTC, are not traded on a formal exchange. While the biggest publicly traded companies trade on stock exchanges like the New York Stock Exchange (NYSE) or NASDAQ, over-the-counter securities trade outside of them, through a network of broker-dealers. These stocks can come in non-standardized variations, and they often have higher trading fees than their formal exchange counterparts.
The Basics of Over-the-Counter (OTC) Trading
Although much of the over-the-counter market revolves around stocks, you can also buy commodities, debt securities and derivatives OTC. These securities are sometimes called unlisted securities, as they aren’t traded on formal exchanges. Instead, they trade on broker-dealer networks like the Over-the-Counter Bulletin Board (OTCBB), Pink Sheets or the Venture Market (OTCQB).
Stocks traded on over-the-counter markets are often those of small or growing companies that can’t meet the requirements of the formal exchanges. However, shares of larger companies can also be traded on the over-the-counter market. This might be a result of the company being delisted from a formal exchange or if it is pursuing bankruptcy protection.
Over-the-counter exchanges do not have a physical location like their formal exchange counterparts. And remember, an OTC exchange is merely a listing of securities. Actual trades are made by brokers, either by phone or online.
Benefits of Over-the-Counter Trading
The over-the-counter market allows companies that do not meet the rules of formal exchanges to list their stock. This might include smaller “up-and-coming” companies. This affords investors immediate access to buy these shares. Because these are often less established companies with low stock prices, there’s always the chance that you hit the jackpot by getting in on the ground floor of these stocks.
OTC exchanges are also known for the wide range of securities they’re willing to list. More specifically, prospective investors can buy from a collection of penny stocks, bonds and derivatives that would otherwise be largely unattainable.
Securities that trade on an OTC exchange often operate on a much smaller scale than larger company stocks like Amazon and Walmart. As a result, OTC trading is usually not for the faint of heart. But if you can stomach the risk that comes with this style of investing, the possible returns might be worth it.
The opportunity for smaller companies to list on an OTC exchange is important for their financial well-being. By opting for over-the-counter investors, a company can generate capital at a rate much faster than if they were to list on a formal exchange.
Potential Drawbacks of OTC Exchanges
The flip side of the potentially strong returns of OTC securities is that risk-averse investors will likely be scared off. In many cases, an OTC exchange will have less stringent regulations than a formal one. This induces a lack of public information about companies, which can make buying their shares much less transparent. So if you purchase an OTC stock, know that there is a risk of default.
Over-the-counter exchanges can sometimes be referred to as “thinly traded.” This means there’s high inventory of securities, but a low demand. An imbalance such as this can have major ramifications, resulting in sudden price fluctuations.
Another risk of over-the-counter securities are their inherently lower liquidity levels than formal exchange investments. Many investors utilize formal exchanges, so when it comes time to sell, there’s no shortage of available buyers. But if you decide to sell your OTC investments, you may have a hard time doing so within the confines of a smaller market.
As is usually the case in investing, the increased risk of over-the-counter trading comes with the possibility of greater rewards. For risk-averse investors, though, the particulars of OTC stock trading – fewer required disclosures from listed companies, less liquidity and even the risk of default – might be too much to bear. Keep this in mind when considering an over-the-counter investment strategy, and proceed with caution.
If over-the-counter investing is something you’re looking to do, think about consulting with a financial advisor. Although not all advisors have experience in this market, many can offer important insights that might be helpful in the long run. After all, you want to make sure that your money is protected for retirement and other important life events.
Tips for Getting Into the Investment Game
- Before you invest any of your hard-earned money, think about consulting with a financial advisor. Finding the right advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Even if OTC stocks sound like the perfect investment for your financial situation, your portfolio should still maintain strong diversification. The best way to ensure your portfolio is diversified is to build an asset allocation. This will dictate what types of investments should occupy specific percentages within your portfolio.
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