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

Cheap stocks that trade outside a traditional exchange are sometimes known as OTC stocks. They often trade at less than $5 per share and are offered by small companies. By not paying to be on a large exchange, companies keep share prices down to woo investors. There is a degree of risk involved for potential investors, but OTC stocks can be a bargain for those who know what they’re looking for.

OTC Stocks Defined

OTC stands for “over the counter,” which means they’re traded directly through a network of brokers and dealers. An OTC trade doesn’t take place on one of the exchanges, such as the New York Stock Exchange or Nasdaq. As a result, such stocks are also called “unlisted.”

OTC stocks may have lower share prices than those of exchange-listed companies. Many OTC stocks trade at under $5 a share and are known as “penny stocks.” Individual investors sometimes 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 significant is the OTC Bulletin Board (OTCBB) is operated by the Financial Industry Regulatory Authority (FINRA). All trades by broker-dealers in the OTC market are overseen by FINRA.

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 requirements for the share price and number of publicly traded shares. Many small companies can’t meet these requirements. The OTC allows those companies to 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 larger 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 is 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 in 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 New York Stock Exchange 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 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.
  • 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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