What is Over the Counter Trading? A Complete Guide

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According to recent estimates, the over the counter (OTC) trading market accounted for a dollar volume of $375.2 billion in 2018. This figure represents a more than 50 percent increase from the year 2017 (up from $246.7 billion). Though the over the counter market has been historically associated with higher risks, there is still clearly a lot of money that can potentially be made.

The term “over the counter” is used to describe any company that can be publicly traded, but is not listed on any formal stock exchanges. Formal exchanges such as the New York Stock Exchange (NYSE) and NASDAQ still account for the majority of trades in the United States. However, OTC markets are able to offer traders additional opportunities via broker-dealer networks.

Not all OTC stocks are necessarily risky. In fact, Bayer and Nestle—two of the world’s most well-known brands—are traded by Americans over the counter. This is because OTC stocks are among the easiest ways for Americans to access stock in a foreign company.

There are quite a few reasons why a stock might be listed OTC, rather than on the NYSE or NASDAQ. In this article, we will discuss the most important things for you to know about trading OTC. We will also discuss how to weather the risks of OTC stocks and become a successful trader.

What is an “Over the Counter” stock?

The term “over the counter” is incredibly broad. It is used to describe any stock that cannot be found on the major exchanges in the United States. While exchanges such as the NYSE may get the most attention in the news, they represent just a portion of the overall stock market.

The OTC market has existed even longer than the NYSE has. Stocks are exchanged directly through a broker-dealer network, rather than through the use of a formal of exchange. In most cases, OTC stocks would not qualify to be listed on the major exchanges.

There are some companies that begin over the counter trading and eventually “graduate” to the major exchanges. In 2018, there were 70 companies that moved from trading over the counter to a national stock exchange. OTC stocks are often viewed as a possible alternative when the risk-reward ratio in the primary exchanges runs askew.

 

Why are the different types of OTC stocks?

There are multiple different “types” of OTC stocks. In 2018, three of these types of stocks accounted for 98 percent of all trades in the OTC market.

  • Pink Sheets
  • OTCQX (Best Market)
  • OTCQB (Venture Market)

The National Association of Securities Dealers (NASD) sets the standards for how these types of stocks will be traded. Using pink sheets and various bulletin boards, these dealers are able to act as market makers. Because the stocks are influenced by the interactions between buyers and dealers, it is possible for them to change in value in a very short amount of time.

In addition to the underlying market, the OTC derivatives market is incredibly huge. According to BIS reports, this market experienced $544 trillion worth of trading activity in 2018 alone. Many traders enjoy the derivatives market due to increased levels of volatility. As long as risks can be properly managed, there will be strong potential for returns.

 

Why are OTC stocks not listed on the NYSE?

There are quite a few reasons why an OTC stock might not be listed on the NYSE, NASDAQ, or other major exchanges. Some of these reasons why will be more concerning to investors than others.

  • The company is located abroad and is already listed on an international exchange (such as Bayer and Nestle)
  • The company has not been able to satisfy various market regulations
  • The company cannot or does not want to pay the fee for listing (currently, it costs $500,000 to list on the NYSE and $75,000 to list on NASDAQ)
  • The company needs to raise a large amount of money in a short amount of time

Many of the stocks you will find trading over the counter are referred to as “penny stocks.” A penny stock is not a stock that costs literally a penny. Instead, this term is used to describe any stock that is currently valued for less than $5 and is not trading on a major exchange. However, there are still some OTC stocks that trade well above $5 per share.

 

What are the risks and benefits of OTC trading?

To be frank, the over the counter market often has a negative reputation among the most experienced traders on Wall Street. Because the OTC market does not have the same standards and regulations as exchange-traded stocks, this market is especially prone to manipulations. Pump and dump schemes—which artificially inflate the value of a stock—are especially common. Another risk of trading these stocks is that they are much liquid. There may not always be a buyer available.

If you are concerned about these schemes or the risks of trading penny stocks, consider exploring the OTCQX Best Market. This portion of the OTC market does not list any penny stocks. Additionally, look for companies that are listed with an “OB” in their name—these companies are required to comply with SEC regulations. Companies listed with a “PK”, however, do not need to comply with SEC regulations.

There are also benefits of trading OTC. Because these stocks are more volatile, there will be profitable trading opportunities over time. Many small companies can be accessed on these markets for very cheap—if these companies eventually grow, you can indeed make a lot of money.

 

How can I become a successful OTC trader?

Succeeding in the OTC market is all about carefully managing risk and reward. The surest way to succeed is to diversify and open many different positions. Even if 90 percent of your positions are failures, the 10 percent that are successes may be enough to keep your portfolio in the black. As long as you’re able to diversify, be aware of common risks, and understand value drivers, you can become a successful OTC trader.

 

Conclusion

The OTC market is an incredibly large market that presents traders with many unique trading opportunities. This market is not without its fair share of risks. However, when managed correctly, the OTC market may be able to give your portfolio the sort of dynamism you’ve looking for.

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