OTC stands for over-the-counter. In trading terms, over-the-counter means trading through broker-dealer networks. A broker-dealer network is simply a market structure consisting of various technical devices. This structure allows investors to create a marketplace without a central location. The opposite of OTC trading is exchange trading, which takes place via a central exchange. Over-the-counter trading can involve equities, debt instruments, and derivatives, which are financial contracts that derive their value from an underlying asset such as a commodity.
In some cases, securities might not meet the requirements to have a listing on a standard market exchange such as the New York Stock Exchange (NYSE). at least, these securities can be traded over-the-counter.
However, over-the-counter trading can include equities that are listed on exchanges and stocks that are not listed. Stocks that are not listed on an exchange, and trade via OTC, are typically called over-the-counter equity securities, or OTC equities.
Understanding Over-the-Counter (OTC)
Stocks that trade via OTC are typically smaller companies that cannot meet the exchange listing requirements of formal exchanges. However, many other types of securities also trade here. Stocks that trade on exchanges are called listed stocks, whereas stocks that trade via OTC are called unlisted stocks.
Trade transactions can take place through the Over the Counter Bulletin Board (OTCBB) or the Pink Sheets listing services. The OTCBB is an electronic quotation and trading service that facilitates higher liquidity and better information sharing.3
A Pink Sheet company is a private company that works with broker-dealers to bring small company shares to the market.
OTC securities trade by broker-dealers who negotiate directly with one another over computer networks and by phone using the OTCBB. The dealers act as market makers using the Pink Sheets and the OTC Bulletin Board, which is provided by the Financial Industry Regulatory Authority (FINRA), which is an agency that writes and enforces the rules governing brokers and broker-dealers.
Pros and Cons of the OTC Marketplace
As mentioned earlier, bonds, ADRs, and derivatives also trade in the OTC marketplace. However, investors should take great care when investing in more speculative OTC securities. The filing requirements between listing platforms vary, and some necessary information, such as business financials, may be hard to locate.
Most financial advisors consider trading in OTC shares as a speculative undertaking. For this reason, investors must consider their investment risk tolerance and if OTC stocks have a place in their portfolios. However, with the added risk of OTC shares comes the possibility of significant returns. Since these shares trade at lower values, and usually, for less transactional costs, they provide an avenue for share price appreciation.
Stocks trading OTC are not, generally, known for their large volume of trades. Lower share volume means there may not be a ready buyer when it comes time to sell your shares. Also, the spread between the bid-price and the ask-price is usually larger. These stocks may make volatile moves on any market or economic data.
The OTC marketplace is an alternative for small companies or those who do not want to list on the standard exchanges. Listing on a standard exchange is an expensive and time-consuming process and outside the financial capabilities of many smaller companies. Companies may also find that listing in the OTC market provides quick access to capital through the sale of shares. As Investopedia states there are pros and cons of Over-the-Counter:
Pros
- OTC provides access to securities not available on standard exchanges such as bonds, ADRs, and derivatives.
- Fewer regulations on the OTC allow the entry of many companies who cannot, or choose not to, list on other exchanges.
- Through the trade of low-cost, penny stock, speculative investors can earn significant returns.
Cons
- OTC stocks have less trade liquidity due to low volume which leads to delays in finalizing the trade and wide bid-ask spreads.
- Less regulation leads to less available public information, the chance of outdated information, and the possibility of fraud.
- OTC stocks are prone to make volatile moves on the release of the market and economic data.
