Risks Associated With OTC Markets

Author: George Davis

Trading in the OTC exchange is a bigger gamble than trading volatile stocks in a formal exchange. Read this article to learn about the risks associated with OTC markets.

OTC or over-the-counter market refers to the process of trading shares in an unconventional method. OTC trades involve the exchange of stocks and equities listed and not listed on formal stock exchanges, like NASDAQ, S&P500, and DOW JONES. OTC trading is not illegal nor is it prohibited since it is regulated by Financial Industry Regulatory Authority (FINRA).

OTC trades are carried out through pink sheets and Over-The-Counter Bulletin Boards (OTCBB). The OTC Bulletin Board is an electronic quotation that supports better information and higher liquidity. Companies that trade their shares in the OTC market are known as “penny stocks.”

These are small companies that cannot make the requirements of a formal exchange. Moreover, OTC trades also include private companies looking to sell small shares of their company. No matter how profitable it might seem to trade cheap stocks, the OTC market comes with its own set of challenges.

Risks Associated With OTC Market

OTC companies offer shares for less than $1; this might seem like a profitable trade to a beginner investor. However, there are a few downsides to trading on the OTC market.

1. Lack of Readily Available Information

OTC exchanges aren’t as regulated as national stock exchanges like NASDAQ and others; this is because OTC exchanges deal in small companies that don’t have much data to share or are simply not willing. The unregulated nature of the OTC market creates ungoverned information, and investors can’t make informed investment decisions. So, when investing in the OTC exchange, you have to follow your gut feeling most of the time.

2. Wide Bid-Ask Spread

The risk associated with OTC trading is that the market is slim for sellers. The bid-ask spread is too wide for the investor to exit the market safely. For example, if an OTC stock’s bid price is $0.05, its ask price would be $0.10; this means that the return on investment immediately drops by 50%. The difference between the two prices may seem small, but buying 1000 stocks at $0.10 and selling them at $0.05 drops the return on investment by $50.

3. Rapid Changes in Price

In contrast to a national-level stock exchange, OTC exchanges have a high price fluctuation rate because the initial price of a share in the OTC market is too low. For instance, if you buy 10,000 shares today, someone else will buy 50,000 shares in the next minute, fluctuating the market by a large scale. On the other hand, formal exchanges don’t have such drastic shifts in prices because only a few big investors can tip the scale.

Ending Note

Despite the risks of trading in an OTC market, many investors are willing to try their luck in exchange for a small change since some OTC stocks have sky-rocketed and made their investors rich. However, the odds of finding the right investment in the OTC exchange are very slim.

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