Over-the-Counter (OTC)

Commonly referred to as off-exchange trading, it happens directly between two parties without involving an exchange.

Author: Matthew Retzloff
Matthew Retzloff
Matthew Retzloff
Investment Banking | Corporate Development

Matthew started his finance career working as an investment banking analyst for Falcon Capital Partners, a healthcare IT boutique, before moving on to work for Raymond James Financial, Inc in their specialty finance coverage group in Atlanta. Matthew then started in a role in corporate development at Babcock & Wilcox before moving to a corporate development associate role with Caesars Entertainment Corporation where he currently is. Matthew provides support to Caesars' M&A processes including evaluating inbound teasers/CIMs to identify possible acquisition targets, due diligence, constructing financial models, corporate valuation, and interacting with potential acquisition targets.

Matthew has a Bachelor of Science in Accounting and Business Administration and a Bachelor of Arts in German from University of North Carolina.

Reviewed By: Osman Ahmed
Osman Ahmed
Osman Ahmed
Investment Banking | Private Equity

Osman started his career as an investment banking analyst at Thomas Weisel Partners where he spent just over two years before moving into a growth equity investing role at Scale Venture Partners, focused on technology. He's currently a VP at KCK Group, the private equity arm of a middle eastern family office. Osman has a generalist industry focus on lower middle market growth equity and buyout transactions.

Osman holds a Bachelor of Science in Computer Science from the University of Southern California and a Master of Business Administration with concentrations in Finance, Entrepreneurship, and Economics from the University of Chicago Booth School of Business.

Last Updated:November 1, 2023

What Is Over-the-Counter (OTC)?

Over-the-counter trading, commonly referred to as off-exchange trading, happens directly between two parties without involving an exchange.

Both over-the-counter and on exchanges, commodities, financial instruments (such as stocks), and their derivatives are exchanged. However, the goods traded on exchanges must adhere to strict standards and regulations.

Securities not listed on large exchanges like the New York Stock Exchange can be traded on such exchanges.

About 12,000 stocks trade over-the-counter. For various reasons, the corporations that issue these stocks opt to trade this way.

Trading such stocks involve using decentralized dealer networks. A decentralized market is a market system made up of several technological tools. Investors can build a marketplace without a central hub thanks to this framework. 

This trading is the reverse of exchange trading through a centralized exchange. These derivatives are one of the many investment options that can help you generate substantial rewards.

Since these market contracts are bilateral (i.e., only involving two parties), either side may be concerned about the other's credit risk. Interest rates, foreign exchange, equities, and commodities are among the asset types where such derivatives are significant. 

"Off-exchange trading" accounted for around 16 percent of all stock transactions in the United States in 2008; by April 2014, that percentage had risen to about 40 percent.

Through direct negotiations, brokers and dealers set up such OTC markets. These markets have the benefit of allowing the trading of non-standard shares or stocks. 

This concept can also be seen in the healthcare sector, and nonprescription medications are other names for over-the-counter drugs. These phrases refer to medications that are available over-the-counter. 

They are safe and effective when used according to the instructions on the label and those given by your healthcare provider. Without a prescription from a doctor, you can purchase such medications from a drugstore or other store.

Understanding Over-the-Counter (OTC)

Smaller securities can often be found on these exchanges. It consists of equities that are exempted from the rules for market capitalization

Companies in bankruptcy proceedings or unable to retain the price per share of their stock above a particular level may also trade on these markets. 

These businesses can trade on such exchange markets but cannot do so on a stock exchange that is highly standardized and regulated. Securities classified as derivatives have prices based on the intrinsic or underlying asset value. 

Among these assets are commodities, equities, bonds, and so on. 

Forwards, futures, options, and swaps are a few examples of derivative securities that are often traded. Trading derivatives can offer protection from risks related to changes in the value of the underlying assets.

The advantages of stock trading on exchanges include a lot of liquidity, transparency, standardization, and upholding the current market price. Whereas, these benefits are not always present in such transactions. 

The term "trading over-the-counter" refers to the securities exchange between two persons outside a stock exchange. Such trading is being carried out in the United States on several exchanges.

The name of the business that runs a public market for securities that, for various reasons, don't trade on significant stock exchanges like the NYSE and the Nasdaq is OTC Markets Group (OTC: OTCM). 

Additionally, it offers OTC Link, a real-time quotation service to market participants. The exchanges that list over 12,000 OTC securities are referred to as OTC markets.

Types of OTC Securities

Many small-company equities that are listed on large exchanges are OTC securities because they don't trade enough shares or because their shares don't sell for more than a minimal price.

A number of the securities traded in these markets have the potential to yield positive returns. 

For instance, these markets commonly feature international stocks, including many shares of well-known businesses.

The different types of financial instruments that are traded OTC are

1. Bonds: Anywhere a buyer and seller can agree on a price is where bonds can be traded. In contrast to publicly traded stocks, bonds are not exchanged on a central market or exchange. 

Instead of being listed on a formal exchange, the bond market is an "over-the-counter" market. Exchanges offer trading in convertible bonds, some bond futures, and bond options.

2. Derivatives: OTC derivatives trading occurs via dealer networks. 

Often called unlisted stocks, these derivatives are not listed. Instead, derivatives trades are executed by the broker/dealer network via direct negotiations, in which both sides agree upon the conditions.

3. Stocks: OTC derivatives trading is done through dealer networks. The term "unlisted stocks" is frequently used to describe these derivatives. 

The broker/dealer network executes derivatives trades through direct negotiations in which both parties reach the terms.

4. Forex and Cryptocurrency: Many foreign currencies and cryptocurrencies trade OTC.

Smaller securities can often be found trading on these markets. It consists of equities that are exempt from the rules for market capitalization. 

Companies in bankruptcy proceedings or unable to retain the price per share of their stock above a particular level may also trade on these markets. These businesses can trade in these markets but not on an exchange.

OTC Markets

The OTC Markets Group is an integral component of these markets. It is a New York-based network of more than 100 broker-dealers. The group quotes and transacts on the OTC markets platform in various securities and markets. 

A network of businesses known as the OTC market acts as a market maker for specific cheap and infrequently traded stocks, such as UK penny stocks. 

Listed stocks are those that trade on an exchange, as opposed to unlisted stocks, which are those that trade over-the-counter.

Nearly 10,000 securities have price and liquidity data provided by the Markets Group. In addition, it runs many of the more well-known networks, including Pink Open Market, OTCQB Venture Market, and OTCQX Best Market.

The two common methods for structuring financial markets are OTC markets and exchange markets. These markets or exchanges must be used to transact in stocks. But some equities are traded on both an exchange and an unregulated market.

Although there are distinctions between major exchanges and these markets, investors shouldn't notice appreciable discrepancies when trading. Moreover, a financial exchange might be considered safer as it is a controlled and standardized market. 

It might also be considered to facilitate quicker transactions. OTC trading takes place for debt securities and other financial products, including derivatives. 

Certain securities, like bonds, are traded through such platforms by investment banks and do not trade on a formal market. Unlisted stocks are traded using systems such as the US's OTCQX, OTCQB, and Pink Sheets (formerly the OTC Bulletin Board and Pink Sheets).

The types of OTC markets are:

1. Pink Sheets

Pink sheet stocks are financial instruments traded on OTC exchanges. In OTC markets, direct transactions typically occur between dealers.

2. OTCQB (Venture Markets)

The middle of the group's three markets for trading such stocks is served by the OTC market exchange known as OTCQB.

The US and foreign businesses in this medium tier are called the Venture Market and are in the entrepreneurial and development stages. Accordingly, OTCQB companies are subject to oversight and must disclose their financial information.

3. OTCQX (Best Markets)

Of the three, this is the pickiest. Only 4% of the equities listed on this exchange are traded there. 

It typically consists of foreign companies that list on significant overseas exchanges and some US companies that intend to someday list on the NYSE or the Nasdaq and have the highest reporting criteria and strictest scrutiny.

How do you trade securities on the over-the-counter markets?

Purchasing such stocks is a fairly simple process. You can buy and sell small penny stocks using most top online brokers because they trade similarly to most other equities. 

You must know the company's ticker symbol and have sufficient funds in your brokerage account to purchase the necessary shares.

Opening an account with an online brokerage that facilitates trading in these stocks is the simplest way to purchase them. But not all online brokers provide these. Fidelity, TD Ameritrade, Charles Schwab, and Interactive Brokers are a few brokerages.

Even though the orders are fulfilled in different locations, the process for purchasing such stocks is the same as the process for purchasing any stock. Some of the most well-known marketplaces are administered by the OTC Markets Group (OTCQX: OTCM).

Risks Involved in Trading OTC Securities

Investors should consider the stock's liquidity while purchasing the shares (and other small company stocks). 

Compared to larger companies with stronger liquidity, smaller companies with fewer outstanding shares may have lower trading volume and less potential to sell shares at a profit.

Since these stocks have low share prices, investors can purchase many with a small initial outlay.

Theoretically, a seller might set one price for a security to be purchased by a buyer and another for a different buyer. However, in these markets, prices are not made public until the trade has been completed.

As a result, a deal can be completed between two parties on an OTC market without anybody else knowing the price of the transaction. Investors may face challenging circumstances as a result of this lack of transparency. 

Comparatively, trading is conducted in a way open to the public on an exchange. As a result, trading such small penny stocks may be subject to less regulation than big exchanges, depending on the market or network you choose to trade via.

Such stocks can also be highly volatile and unexpected, which is another aspect. Therefore, while trading in these stocks, it is advised to use risk management strategies because they may be the target of market manipulation

Once the position has moved a certain amount of points against the trader, a stop-loss order will automatically close the position. Likewise, when a position moves a specific number of points in the trader's favor, a limit will automatically close the position. 

These securities have a lower trading volume, which could cause sudden price changes. Traders can establish triggers for both orders at predefined price levels, allowing them to predetermine their profit and loss margins.

Conclusion

These exchanges allow for purchasing OTC equities from approved brokers. They are inexpensive and offer good rewards if the stock does well, but the hazards are also substantial.

They are not only traded differently from equities listed on an exchange but also carry higher risks, which investors should carefully consider.

According to the famous trader and founder of the OVEX cryptocurrency exchange platform Jon Ovadia, fees are cheaper in these markets than on significant exchanges.

These stocks are frequently subject to allegations of market manipulation, produce poor investment returns with high volatility, and infrequently expand into big businesses or get listed on stock exchanges.

Most experts advise staying away from it or, at the very least, limiting your trading to the OTCQX Best Market tier on OTC Markets Group if your investment approach is exceptionally conservative or a relative newcomer.

You may avoid scams and other undesirable investments in these markets and concentrate on discovering reliable long-term investments as long as you comprehend such a marketplace and study the stocks that catch your attention.

Another factor is the extreme volatility and unpredictability of such stocks. Therefore, it is advised to utilize risk management techniques when trading OTC instruments because they could become the focus of market manipulation. 

A stop-loss order will automatically close the position once the position has moved a certain number of points in the trader's direction.

Researched and authorized by Marazban Tavadia LinkedIn

Reviewed and edited by Parul Gupta LinkedIn

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