The Top 3 Risks With Trading OTC Markets
The OTC Markets (Over The Counter) is a market for stocks that don’t meet the requirements for being listed on a major exchange like the NYSE or NASDAQ and has become somewhat of a wild, wild west arena over the years.
However, it still attracts a plethora of traders and investors who are looking to trade cheap stocks, most of them of which are trading under a dollar and even at a fraction of a penny. The OTC Markets is a very risky place to trade so below we will go over what we think are the top risks involved with trading it.
What Is The OTC Markets?
The OTC Markets is an informal market where various securities dealers have established a network for trading shares. Unlike a formal market, such as the NYSE, the companies whose securities are sold have much less stringent reporting requirements and are often new and unproven companies looking for capital.
Furthermore, the dealers themselves are able to operate under much laxer rules of conduct and regulatory scrutiny. The end product is a market that allows traders to buy and sell securities without a lot of the structure and safety that formal markets are designed to establish.
Due to the lax rules and regulations, the OTC has become haven for “pump and dump” schemes that has costs investors millions of dollars and is why we recommend new traders stay away from the OTC markets and rather focus on cheaper listed securities.
So what are the main risks involved with trading in over the counter markets?
Companies that trade in over the counter markets have a much less stringent reporting standard to follow. This leads to companies being far more opaque than traders are used to from trading listed shares on formal markets.
Less publicly available and verifiable information means that identifying an appropriate price can be much more difficult and that the companies have an incentive to bend the rules as far as they can in their own favor. This puts traders at risk of making poor decisions or following false information, and requires a much more informal approach to valuing companies.
There has been numerous cases of companies misleading investors on the OTC markets with false information and shady business dealings. You really can’t trust anything that has been released by companies on the OTC. Bottom-line is you can’t invest in a company based on fundamentals that trades on the OTC.
Low Market Capitalization
The generally much lower value of the companies that trade in over the counter markets makes their stocks more vulnerable to attempts at manipulation and pump and dump schemes. The companies that trade on formal exchanges have such large market capitalization that very few investors are able to significantly affect the price of a stock merely by trading it. By contrast, over the counter markets contain many stocks whose prices will change dramatically from a relatively small trading volume which means anyone with a decent sized account and manipulate the prices.
Pump and dumps happen when a trader or group of traders load up on a stock and then pump it up on message boards and social media outlets. This gets other traders interested and provides enough liquidity for the original buyers to dump there shares at a higher price which will then likely push prices even lower, leaving the unsuspected investor holding the bag.
It is important to understand why the price of a stock is changing before you decide to trade it. Some traders may simply be trying to drive the price of a stock up or down through manipulation, and this price change will not reflect any real permanent change in the value of the stock.
Light Volume & Wide Spreads
With stocks on the OTC you can expect trading volume to be much lighter and less competitive compared to listed stocks and with this you will also experience wider spreads. This makes getting fills at good prices harder and if you have any size it could be difficult to exit a position which could result in huge losses.
Trading in a low liquidity over the counter market requires much more care when entering orders and traders should avoid market orders at all cost. Slippage can be through the roof and can ruin a profitable trade.
Over the Counter Markets Pros and Cons
The different structure of over the counter markets means that they have different advantages and disadvantages for traders. Traders who go in expecting the same rules and regulations of formal markets will be in for a rough time, but savvy traders who understand the nature of over the counter markets are in a position to profit from the inefficiencies presented in the OTC.
We always urge new traders to minimize risk and trade small and that is even more important in the OTC markets.
As a result of their lack of transparency and their generally low-liquidity assets, the OTC is not something we trade or would recommend trading. There are plenty of low priced stocks that are listed on a major exchange to trade with plenty of upside potential.
Don’t be tricked into thinking you can win the lottery playing this really cheap stocks because you can buy thousands of shares for next to nothing. Most of the time, it’s just scam!