Complete Guide to OTC Trading

Do you see the stock market as the end-all, be-all of investing?

Spoiler alert: it’s not.

Like the ever-expanding universe, there are always new interesting stocks popping up in the vast arena of financial markets. However, some of these can’t be traded on popular exchanges like the NYSE.

But, they are usually available on the OTC markets. 📈

These “irregular” stock include downright bad, risky companies, but also aspiring tech and other corporations in the making. Among OTC stock, you’ll also find foreign giants like BMW that you can’t trade via American stock markets. Because of this, OTC trading is at least worth a look, right?

In a survey by JP Morgan Chase, some 42% of the people who did not invest in the pre-pandemic market said that it’s simply because their living expenses and existing debt were too heavy a load. This is understandable—a downturn in the economy combined with a booming, expensive stock market is not an ideal investing situation for everyone.

This is one of the reasons why new investors often take a dip in the OTC markets—the stocks on display can often be super-cheap, and reputable foreign companies are a good, reliable hedge against another downturn in the U.S. economy, as well as the ever-growing USD inflation rates.

However, one should not jump into the vast expanse of the OTC market unprepared. That’s why we made a guide that will tell you how OTC trading works, what it encompasses, and what its risks are. But with the right know-how, a trip outside the known regions of investing can be fun, and possible very profitable.

So, let’s dive straight into it! 🤿

What is OTC Trading? 🔎

Over-the-counter (OTC) trading is the process of direct trading of securities between two parties—you and a broker-dealer network, without the supervision of a centralized exchange. Simply put, OTC markets are like buying groceries (stocks) from a salesman on the farmer’s market (dealer-broker network) instead of getting it from marketplaces like Walmart (NYSE). 

OTC trading is contrasted with exchange trading that occurs via a centralized exchange like NYSE, or NASDAQ. At times, OTC markets are also referred to as ‘junior markets’—most companies taking part don’t meet the stringent requirements of major stock exchanges.

Many micro-capitalization companies that are part of the OTC market are seen to have great potential because they often invest in promising R&D and develop new products and technologies. Recently, the White House’s issued plans to renew and rebuild American infrastructure, which makes it only fair to consider a company like Williams Industrial Service Group Inc. (WLMS).

Examples like SIRIUS XM (SIRI) that started to trade as a penny stock have caught the attention of investors and soon shifted their base to NASDAQ in 2020 after a merger with XM. However, the lack of regulation and other aspects of OTC trading, shouldn’t bar you from losing out on such a lucrative opportunity. Therefore, it only makes sense to get acclimatized with the know-how of the OTC market and avoid catastrophic losses.

How Does OTC Trading Work? 🏗

As mentioned earlier, OTC markets are not under the control of a regulatory body. This implies that dealers have a free hand and freedom to decide what, how much to trade, at a price of their choice. 

Unlike how regular stock markets work, OTC markets typically trade the stocks of smaller companies that cannot meet the stringent exchange listing and capital requirements for formal exchanges. To put things into perspective, the listing price on a major stock exchange can go up to $250,000/year, which is a fee every small company would want to avoid like the plague.

The OTC trading stocks are referred to as unlisted stocks. As an individual investor, you would have to choose a dealer-broker network to start setting up your OTC orders to start buying or selling. You can have investment banks work as an intermediary to take care of your deals, but then you would have to trade at their discretion—investing where they let you.

Due to the lack of rules, the broker-dealers needn’t disclose the price of the security to anyone in the market. This can result in irregular or less information in the public domain which increases the uncertainty in the trade. 

Besides, without an overlooking body to take care of complaints and grievances, investors would be left in a lurch in case of any misdeeds—like the ones carried out by Stratton Oakmont from the Wolf of the Wall Street (Reels, but you get the point). 

OTC Trading Markets 👇

The OTC Markets Group operates well-known networks, like the Venture Market (OTCQB), the Best Market (OTCQX), and the Pink Open Market. Financial Industry Regulatory Authority (FINRA) body that writes and enforces the rules that govern the broker-dealer’s network in the OTCBB and pink sheet market. However, the standard rules on the OTCBB market are much stricter, which sets them apart from the penny stocks.

Besides, the tiers in the OTC markets determine which stocks get traded where. Similar to the stock exchange, OTC networks also have some eligibility requirements that stocks have to meet. For instance, the OTCQX does not include companies that sell penny stock, shell companies, or businesses at the brink of bankruptcy. 

As it holds the top-tier advantage, OTCQX Best Market prefers companies with greater liquidity and the largest market caps compared to other OTC markets. This market trades shares of successful businesses like Bayer A.G., Nestle SA, Allianz SE, and Danone SA.

Over the Counter Bulletin Board (OTCBB) is the middle-tier market that involves the electronic quotation and trading service that helps investors navigate through better information sharing and gain liquidity. Although they continue to provide market information through FINRA’s website, in 2020, FINRA has filed a rule change with SEC. It proposes to cease its operation and it is looking to be replaced by OTCQB. 

Pink sheets companies are private companies that work with broker-dealers to get small company shares to the trading market. It involves smaller transactional costs, but the risk is high as they are prime targets for market manipulation. These stocks don’t meet Securities and Exchange Commission (SEC) requirements and therefore needn’t file their financials with them.

There are also instances, where companies jump from the one to the highest strata. One such example is Digihost Technology Inc, which recently announced its upgraded listing from OTC Pink Sheets to OTCQB in the U.S. Market.

Types of OTC Investments 🗂

The financial stock market is organized by the OTC and exchange markets. While some stocks only trade through one of the markets, some stocks can be traded on both the exchange and OTC markets.

One of the prevalent stocks traded on OTC markets is American depository receipts (ADRs). These stocks mostly represent shares in companies that trade on foreign exchange. Most financial instruments like bonds are traded on OTC markets.

Few other financial instruments, such as derivatives, also get traded through the broker-dealer network. OTC markets also trade equities of just not small companies, but some well-known large companies too. For a long time, corporations like Blackberry (BS) and Ford have traded as pink sheet shares. 

The Good and the Bad with OTC Trading

Advantages of OTC Trading ✅

OTC trading might not look like a lucrative investment, but it has its own share of advantages. Let’s quickly take a look at what helps it to stand out:

1. Messiah for Unlisted and Small Companies ✔️

OTC markets consist of stocks of companies that can’t or do not wish to meet immersive capital and strict requirements of bigger exchanges. The OTC markets provide opportunities for such companies to trade as “penny stocks” or other unlisted stocks and get their shares to the market.

Besides, one of its biggest advantages is there’s no cap on the price of the security in OTC markets. This is not the case on a regulated stock exchange where at times a company’s stock price can’t go beyond a certain limit. Besides, investors can also get to trade in stocks of companies with failing financials, even the ones that are about to go bankrupt. While such trades have high risk, they may also yield high profits. 

Recently, in June 2020, the market saw investors rallying up in buying stocks everywhere, even including shares in bankrupt companies like Hertz, Whiting Petroleum, Pier 1, and J.C. Penney. All four organizations declared bankruptcy during the pandemic and saw their shares surging at least 70% at one point since, making this a very lucrative black swan event for OTC traders.

2. No Rules and Regulations ✔️

The OTC markets aren’t so rigid and are free from most rules and regulations of a centralized exchange. Although FINRA does write the rules and observe the markets to some extent, the situation at the major stock exchanges is much more strict. 

Hence, it means involved parties can trade easily at any share volume and seal the deal on their own terms—it isn’t mandatory for the OTC markets to report anything if they aren’t specifically asked to by the authorities. Besides, in absence of any such regulatory body, there’s no exchange fee payment as well.

3. Privacy ✔️

Without any mandatory disclosure requirements, most OTC market trade details like pricing and contract terms are often kept under wraps. This secrecy can be advantageous for big investors as it allows them to buy stock without attracting public attention. However, this is really not a plus for beginners, who might not know where to look and how to analyze stocks. 

4. Contract Customization ✔️

The trading parties are allowed to customize the OTC contracts as per their needs and requirements. Pricing, trade volumes, delivery timelines—you can tweak as it suits you. This allows for more flexibility and gives investors the chance to buy stock at otherwise impossibly favorable terms.

Risks of OTC Trading ⚠️

OTC markets are characterized by risks of frauds for investment. However, recent years have brought improvements with the availability of information and higher liquidity. Electronic quotation and trading have also added enhancement to the otherwise foggy OTC market. 

Here’s a list of risks you might take while OTC trading:

1. Regulation 🚨

Due to much looser regulation, contracts aren’t enforced as strictly as on the regular markets. Needless to say, one of the parties can always refuse to honor the contract previously agreed upon. And even if they want to be good, the other parties can also face a sudden financial crisis. Such events are bound to pose a threat to the agreement and shake the confidence of even the most seasoned investors. 

Moreover, it can lead to major financial losses for a party who would have nowhere to complain as the OTC trading is not well-regulated and perpetrators aren’t punished or penalized. While the brokers and dealers are regulated in the OTCBB market by FINRA, there still needs to be more stringent regulation in place for OTC markets for them to be truly reliable.

Recently, a $100 million company that owns only a single New Jersey deli was delisted from the OTCQB over-the-counter market. The regulating body delisted the company for not complying with the set rules and is a definite alarm-bell for the would-be stock buyers.

2. Liquidity 🚨

In the OTC markets, trading securities can lead to a massive liquidity crunch. While there are sellers available to sell securities, there’s a solid dearth of suitable buyers. The absence of a regulated mechanism in such markets may further aggravate the liquidity risk.

For example, during the 2008 financial crisis, there was an absence of buyers for the complex derivatives and collateralized debt. This led these complex instruments to be traded in large volumes on the OTC market. Once the housing debts came crashing down, in no time, buyers vanished from the market that led to a severe liquidity crunch for the holders—i.e. they weren’t able to find buyers to sell off their decreasing assets.

3. Transparency 🚨

Remember the Suits Episode where a woman who carried out a huge penny stock trade was sued and put in jail? The Suits boys came to her rescue and figured out how the dealer-broker network was carrying out fraud trades until that single large volume trade.

What can we conclude from the situation? OTC markets have long lacked transparency in terms of information on trade. With few regulation practices in place, it’s not mandatory for parties to disclose the trade prices until the trade is completed. Typically most deals take place virtually on a one-on-one basis with intermediaries in place and without others being aware of the price point of the transaction.

The sheer lack of transparency in the OTC markets may often put participants in adverse situations. At times, a buyer might buy securities at a much higher price than their actual worth and later fail to sell at a profit. This is one arena where the regulated exchanges play fair with proper pricing and other detailed disclosures to reduce potential fraud and keep participants’ trust level intact. 

4. Volatility 🚨

Typically, OTC markets are regarded as quite volatile and unpredictable. The lack of regulations can lead to market manipulation, and the price of a security is essentially left to the discretion of market managers. Therefore, effective risk management techniques are recommended for investors to minimize the chances of a loss.

Naturally, using stop-loss orders is a must because you want to close a position once it moves a certain number of points in the direction you don’t like. For both basic types of orders—limit and market—traders can set alerts at predetermined price levels to determine their profit or loss amounts in advance.

In January, six companies whose stocks were selling for less than $1 made up nearly a fifth of U.S. trading. An unbelievable feat, right? Indeed, it was, but it did ring a bell with experts. Although the investment looks alluring, it might be too risky as some investors might get exposed to pump and dump schemes.

How to Buy OTC Stocks 🤝

Wondering if buying OTC stocks similar to buying regular stocks? Fortunately, yes. While buying stocks, one needs to be careful of the supply and demand, trading volume, the timing of the trade, etc. in the market to determine prices. 

Simply put, once an individual investor like you shows interest to buy and/or sell securities, the broker-dealer tries to match up the order internally or by executing with the external broker-dealers.

In simple terms, the trade price is determined by the investor and the dealer-broker network. Besides, the volatility of OTC trading often plays a role in decision-making. Therefore, when you decide to dip your toes in OTC trading, you can come back to this step-by-step guide on how to buy OTC stocks to avoid any repercussions.

But enough investing theory—here is a step-by-step Guide on how to actually buy OTC stock.

Step 1: Select Your Broker-Dealer ✅

Similar to trading on regular markets, OTC trading also requires investors to have an account at a FINRA-registered broker-dealer. Start by choosing a suitable broker-dealer to begin your OTC investing journey. If you’re looking to only invest in penny stocks, you can check out the leading penny stock brokers to help you separate diamonds from coals. Our picks are TradeStation or E*Trade, who equip with the right tools and research to sail through the risks.

Step 2: Time to Make an Investment Decision ✅

Investment decisions don’t come easy, but identifying undervalued stocks through good research is key—and having good info on the stock you’re trading is imperative. However, unlike the regulated stock exchanges where investors can have a fair deal of data to analyze, OTC trading stocks lack a little on that front. While we can be frantic about it, few indicators can help you identify the best OTC stock.

Remember, most investors buy trades on an emotional whim or on a tip of recommendation, without researching the length and breadth about it. Nonetheless, invest your time in researching stocks on the OTCQB, OTCQX, and pink sheet markets. You can also check websites like OTCmarkets.com and other sources to get hold of information on the companies numbers and finances. This information includes past trade data, news on the company’s leadership, business, and complete financials to navigate through your investment plan.

Step 3: Define Your Order ✅

An investor can specify the order type they wish their broker-dealer to handle with two primary order types—market order and limit order. It is upon the investors to decide whether they want to decide if the price or immediacy of the trade, what is more important.

Limit orders are transactions where the investors set the maximum and minimum price for the sell or buy order. Although it is meant to offer price protection to the investor, the order can’t be executed if the security price does reach the price specified. However, market orders allow the dealer-broker to execute the order as quickly as possible at the current price.

For instance, if an investor fixes its limit order to buy the security of XYZ stock at $50, then it will only be executed if the buyer/seller puts up an ask or the offer price at $50 or less. But, even if the offer price crosses $50 and stands at $50.01 or greater, then the limit order can’t be a marketable order and the trade won’t be executed. 

Step 4: Time to Handle the Order ✅

Once the broker-dealer network is specified of the order, it undergoes few following steps:

Internal Trade Execution: Before publishing a quote or looking externally for a trade, the broker-dealers typically try to determine if the order can be executed internally. The network tries to successfully ‘match’ the prices or provide liquidity against their own trading account at the best available quoted price or better at that specific point in time. This is important and the rule came to be called Best Execution. 

Execute Trade Externally:  If the dealer-broker network fails to, or chooses not to, trade internally they will attempt to execute the marketable trade externally. OTC Link® ATS offers capabilities— that help facilitate the process to determine if the order is even marketable or not.

Step 5: Report, Clear, and Settling Trade ✅

After the broker-dealers accept a trade offer through electronic means of communication, it is essential to report it to FINRA, clear it, and then settle it. A significant part of this fifth step involves getting a green signal on the final settlement trade with the investor, who has the final say. But, the mentioned trade will remain incomplete until the final settlement between the seller and buyer. 

The Bottom Line 🏁

If you’ve come this far—congrats. Investing in stocks requires diligence and commitment and can get demanding at times. Although OTC trading might not look thrifty on papers, the commitment to stick to the basics will help you preserve your wallet.

With all the information laid out in this guide, don’t hesitate to return to it whenever you need to get back to basics. Either way, just take the knowledge all in to break into the OTC trading and enhance your personal finance. Also, try to think it through before you make any investment—as you have seen, OTC trading is hard to predict but not without its perks.

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