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Here's everything you need to know about otc stocks.

Over-the-counter (OTC) stocks are also known as unlisted stocks. Typically offered by small companies, they are traded through market makers, rather than through stock exchanges like the New York Stock Exchange or Nasdaq. As a result, OTC stocks generally have a lower volume of trade than exchange-listed stocks and come with a higher degree of risk. Penny stocks are very cheap OTC stocks, which are typically priced at less than $5 per share. Most full-service brokerages can help you place orders for OTC stocks. For guidance on whether you should get into OTC stocks, you may want to consult a financial advisor.

The Definition of OTC Stocks 

As just noted, over-the-counter (OTC) stocks are traded directly through a network of market makers or broker-dealers. OTC stocks are not listed on national securities exchanges, such as the New York Stock Exchange (NYSE) or Nasdaq, which is why they are called unlisted.

OTC stocks typically have lower share prices than those of exchange-listed companies. Many OTC stocks trade at less than $5 a share and are known as penny stocks or micro cap stocks. Individual investors may find them attractive because of their low prices. However, these inexpensive shares can be risky and highly speculative.

OTC trades take place on various electronic platforms. One of the more well-known ones is the OTC Bulletin Board (OTCBB), which was operated by the Financial Industry Regulatory Authority (FINRA) before it was sold to investment bank Rodman & Renshaw.

Another OTC platform is OTC Link, part of the OTC Markets Group. Companies trading on OTC Link tend to be smaller, with fewer shares outstanding and low trading volumes. Shares traded on both of these platforms are often called “pink sheets”  because the color of paper on which quotes of share prices were published years ago. The paper is gone, but low-priced penny stocks are still traded as “pink sheets.”

Uses of OTC

Here's everything you need to know about otc stocks.

OTC stocks allow small companies to sell shares and investors to trade them. Major exchanges have minimum capitalization and other requirements that many small companies can’t meet. So selling shares OTC allows them to raise capital and sell shares without meeting those standards.

Not all OTC companies are small, however. Some large companies trade on the OTC market because they choose to avoid traditional exchanges’ requirements, which may include filing extensive financial reports.

Cost is also a factor. A listing on the Nasdaq, for instance, costs $50,000 to $75,000. To maintain a listing, companies have to pay similar annual fees.

Companies that were on major exchanges often end up on OTC platforms once they have been delisted. If the company’s value falls below the exchange’s minimum, it can be delisted.

Other OTC Securities

OTC trades may include other kinds of securities besides stocks. Corporate and government bonds, derivatives, and other securities also trade on OTC markets.

OTC platforms are also a place to trade American Depository Receipts (ADRs). These are certificates representing shares of foreign companies. Many ADRs are for shares in large, profitable companies that opt not to meet U.S. exchanges’ listing requirements.

Derivatives are also traded on OTC markets. Derivatives are contracts that get their value from an underlying asset. The underlying assets may include equities, indexes or futures. Derivatives are widely used in hedging strategies.

Bonds can also trade on the OTC markets rather than on regular exchanges. Investment banks that issue the bonds save money by not having to list on exchanges.

Exchange-listed companies may also trade on the OTC. When this happens, the traders may be large institutions seeking to make a large trade of thousands of shares. The OTC platforms let them do this without revealing their identities or having an impact on share prices.

How to Trade OTC

Here's everything you need to know about otc stocks.

For investors, trading OTC shares is like trading exchange-listed shares. Many major brokerages can handle OTC stock trades.

Brokers may have different, often lower, fees when trading OTC stocks. Trades may also take somewhat longer than with exchange-listed shares.

However, there are significant differences when investing in OTC shares. Those shares require more research and due diligence than trading exchange-listed shares.

Companies listed on the NYSE and Nasdaq have to file audited financial reports with the SEC. OTC filing requirements vary by platform, but some companies on OTC markets may not have to file financial reports.

The lack of transparency can make it hard for investors to know what they are buying. Without any reporting requirements, investors can fall victim to  fraudulent investment schemes.

Securities traded on the OTC markets may be inherently more risky. Smaller companies tend to be less capitalized. Derivatives are also complex and difficult for novice investors to understand.

OTC companies also tend to trade in much lower volumes. When fewer shares are traded, the difference between bid and ask prices may be wide. It may be difficult for a seller to find a willing buyer when the time comes to sell.

Bottom Line

Many of the investors trading on the OTC markets are large institutions such as mutual fund companies. However, individual investors also own many of the low-priced OTC penny stocks.

The OTC markets serve important purposes for trading bonds, ADRs, derivatives and shares of smaller companies. Some major companies began as low-priced OTC stocks. But the added risk of trading in the OTC markets is a consideration for any prudent investor.

Investing Tips

  • Are OTC shares a good fit for you portfolio? A financial advisor can help answer that question. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free matching tool connects you with up to three financial advisors in your area.
  • Penny stocks can be risky, but some of them can be outright traps for investors. SmartAsset can help you sniff out pushy penny stock promoters and potential pump and dump scams while protecting your portfolio.

Photo credit: ©iStock.com/acilo, ©iStock.com/Anchiy, ©iStock.com/William_Potter

Mark Henricks Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
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