You,ve probably heard of the term OTC stock or penny stock from a water cooler discussion. OTC stocks were called as such because decades ago, that was how US investors actually bought and sold stocks over the counter at their local broker’s office. To fully understand OTC stocks, let’s look at how they fare side by side with regular stocks.
Where the money rolls
An over-the-counter (OTC) stock is also known as unlisted stock meaning it is not listed in traditional stock exchanges such as the New York Stock Exchange (NYSE) or the Nasdaq. OTC stocks are traded by broker-dealers who negotiate through a dealer network instead of a centralized trading facility like the NYSE.
Unlike regular security transactions that are conducted through a formal exchange, OTC stocks are traded directly between two parties, the buyer and the seller. In the United States, OTC securities are traded on two electronic quotation services the OTC Bulletin Board and the Pink Sheets.
Who the players are
The stock exchange is where the big boys play. The who’s who of Wall Street can be found on the NYSE or Nasdaq. Meanwhile, OTC securities that trade over the counter are generally startup companies, small companies with limited operations, companies with bad credit records, or companies that have been delisted from stock exchanges.
Blue vs pink
Securities traded by well-established, financially sound companies are called blue-chip stocks. These stocks are generally less risky than OTC stocks because blue chip companies have the ability to weather economic downturns and operate profitably in the face of adverse financial conditions. Penny stocks that trade on the pink sheets are a more volatile investment. They do not have much liquidity, so finding buyers can be difficult.
The problem with OTC stocks
Fraudsters are ubiquitous in the OTC market, and one pervasive scam is called Pump and Dump. A group of people will buy a penny stock at an incredibly low price, then hype up the stock through email spamming and telephone marketing.
Naive investors will fall for their marketing gimmicks and buy shares, boosting up the stock price. Once the price goes up, these fraudsters will stop buying and sell all their shares, also called dumping. Innocent investors end up with shares that nobody wants to buy and eventually lose all of their investment within days.
Another major risk with OTC stocks is the unregulated environment. While the NYSE and the Nasdaq impose strict rules and regulations on companies with stocks listed on them, the OTC Bulletin Board and the Pink Sheets do not require companies to file quarterly documents with the SEC. Neither are they compelled to disclose the state of their finances or report any operation irregularities.
Investors should be aware that investing in OTC stocks involves a high degree of risk. A thorough research about the financial health, leadership, operations and earnings history of the company must be done before investing. However, if you find the right company, OTC stocks can provide huge rates of return because they’re inexpensive and they have the potential to increase profits in a short period.