If you’re a day trader that doesn’t mind some risk, you may find yourself interested in penny stocks.
These stocks have the potential for huge returns but they come with a lot of risks.
One of the reasons why they are considered risky investments is because, in most cases, they are traded in over-the-counter (OTC) markets. This means they belong to companies that are usually unprofitable and too small to be listed on major exchanges such as the New York Stock Exchange (NYSE) or the NASDAQ.
In this guide, we’ll look at penny stocks and dive into greater detail on OTC markets to help you better understand why these markets have more risk.
What does the term “penny stock” mean?
In spite of their name, penny stocks sometimes change hands for more than a dollar. As a matter of fact, the U.S. Securities and Exchange Commission (SEC) defines a penny stock as any security issued by a tiny company that trades at less than $5 per share.
However, the core idea of penny stocks is they are the smallest companies, the backwater of the stock market. While some stocks listed on the NASDAQ or the NYSE meet the SEC’s definition of penny stock, the vast majority trade over the counter.
What is an over-the-counter (OTC) market?
An over-the-counter (OTC) market is an electronic network that allows two traders to trade stocks with each other using a dealer-broker who acts as a middleman. OTC markets are known as dealer markets or networks.
In contrast, major stock exchanges like the NYSE or the NASDAQ are auction markets. The price of the stock is posted (the “ask”), and then traders make offers for it, bidding against each other.
While companies that trade OTC are regarded as public, they are unlisted. What this means that their stocks can be openly sold or bought, but they are not listed on a formal exchange.
Therefore, these stocks are not subject to the requirements and rules that major exchanges impose on their listed companies. In other words, no governing institution is paying attention to OTC stocks.
In a nutshell, the OTC market is like a Wild West arena, where almost anything goes and there are no listing requirements.
How the OTC market works
In over-the-counter markets, stock trades are done via telephone, fax, email, or in-person between private individuals, without a central exchange location for all traders.
Companies trading on these markets are generally very tiny businesses or those recently started, which means their stocks cannot be listed on a formal stock exchange.
However, it is important to point out that an OTC status does not indicate that a company is not stable or not worthy of being listed on a major exchange.
Many profitable firms can fail to qualify for a NASDAQ or NYSE listing by virtue of the fact that they don’t have enough years in operation to qualify, enough shares of outstanding stock, or high-enough revenues.
You are also likely to find stocks of household-name multinational conglomerates in these markets. Likewise, OTC traders range from new traders to experienced traders. In addition to trading stocks over the counter, traders can buy or sell commodities, bonds, and derivatives.
Why do OTC markets have more risk than listed exchanges?
As we mentioned before, companies whose stocks trade over the counter are not regulated. Unlike companies that are listed on the NYSE or the NASDAQ exchange, OTC companies are not obliged to meet quarterly reporting requirements or any specific compliance rules.
So, like buying a used vehicle, traders are left to trust whatever information is provided to them, making OTC stocks risky securities.
Moreover, because of the less-stringent reporting requirements for stocks listed in over-the-counter markets, fraud is more likely in the market than when you trade the stocks that are listed on a major exchange.
Why new traders should avoid OTC markets
The main reasons why new traders should avoid over the counter markets are:
Lack of transparency
Companies whose stocks trade in OTC markets have a much less stringent reporting standard to follow. This leads to the stocks being far more opaque than traders are used to from exchanges.
Less verifiable and publicly available information means that OTC companies have an incentive to bend the rules as far as they can in their own favor and identifying an appropriate price can be much more difficult.
This puts OTC traders at risk of relying on false information or making poor decisions.
Big spreads, low volume
With over-the-counter penny stocks, trading volume tends to be less competitive and much lighter compared to listed stocks. With this, traders also tend to experience wider spreads.
This makes getting fills at good prices more difficult and if you have any size it could be hard to get out of a position which could result in massive losses.
Trading in light volume in an over-the-counter market requires extreme care when entering orders and you should stay clear of market orders at any cost.
Low market cap
Stocks that trade in over-the-counter markets are more vulnerable to pump and dump schemes and attempts at manipulation. This is because of the much lower value of the companies that offer them.
The stocks that trade on the NYSE and NASDAQ have such big market caps that very few traders are able to greatly weigh on the price of a stock.
By contrast, OTC markets have so many stocks whose prices change significantly from a relatively small trading volume. This means any trader that has a decent-sized account can manipulate the prices.
A pump-and-dump scheme happens when a trader or a group of traders artificially inflates the price of a given stock. They already own a huge position and by promoting it on social media sites and message boards they can move the stock fairly easy.
This causes many traders to jump on the bandwagon and also offers sufficient liquidity for the original buyers to unload their shares (dump) at a higher price. Shares usually fall after this, causing the unaware buyers to lose big.
While OTC markets attract day traders who are looking to trade low-priced stocks, stocks in these markets should treated as highly speculative.
According to the SEC, “Academic studies find that OTC stocks tend to be:
- highly illiquid
- are frequent targets of alleged market manipulation
- generate negative and volatile investment returns on average
- rarely grow into a large company or transition to listing on a stock exchange
There have been many cases of companies misleading traders on the OTC markets with shady business dealings and false information.
You really can’t trust any press release that has been published by companies on the OTC.
So, avoid making OTC penny stocks a key component of your portfolio and stick to those that are listed on well-regulated exchanges.
In addition, make sure to visit the FINRA website to research and prepare for the penny stocks you expect to trade on OTC markets.