The process of purchasing over-the-counter (OTC) stocks is different from purchasing stocks from companies on the New York Stock Exchange (NYSE) and the NASDAQ. The reason is that OTC securities are unlisted, so there is no central exchange for the market. All orders of OTC securities must be made through market makers who actually carry an inventory of securities to facilitate trading instead of just matching orders.

How to Trade OTC Stocks

The first step an investor must make before they can trade in OTC securities is to open an account with a brokerage firm. An investor can choose from either a discount broker or a full-service broker to invest. However, investors should be aware that not all brokers allow trading in OTC securities. An investor's broker will work with the applicable market maker to ensure that the transaction process is completed successfully.

Here is an example of the steps that are taken when an investor makes a market buy order for an OTC stock. After the investor places the market order with his or her broker, the broker must now contact the security's respective market maker. The market maker will then quote the broker the ask price that the market maker is willing to sell the security at. Bid and ask quotes can be monitored constantly by an investor through the Over-The-Counter Bulletin Board (OTCBB).

Since the order was a market order, the broker must accept the price quoted. The broker will transfer the necessary funds to the market maker's account, and is subsequently credited with the respective securities. If the investor wishes to do so, they can place limit or stop orders for OTC securities in order to implement price limits. A similar process is carried out when an investor decides to sell an OTC security.

How OTC Stocks are Different from Other stocks

Major stock exchanges tend to have stringent listing requirements, which companies must meet before their shares may be traded. There are many examples of companies with shares being listed for several years, only to be delisted from the exchange they traded on. These shares need to trade somewhere. Tens of thousands of small and micro-capitalization companies are traded on OTC exchanges around the world.

There is a difference between two companies each with $1 billion in market capitalization, the first with 10 billion shares priced at $0.10 each and the second with 10 million shares priced at $100, all other things being equal. No company with a market capitalization of that size would maintain such a low share price. The $100 price is much more likely. Why do companies do this? The reasons are elusive. In general, the tighter a company's float, the more pronounced an effect large buying has on the price of a stock. Major successful stocks, such as Microsoft (MSFT), Facebook (FB) and Tesla (TSLA), all first listed their shares on the NYSE or Nasdaq with prices above $10.

Most common stocks with real potential are priced over $15 per share and are listed on the NYSE or Nasdaq. Stocks priced below $1, which trade over-the-counter, have murkier financial outlooks, and (generally) are very speculative and risky.

Can Investors Short Sell OTC Stocks?

Although short selling is allowed on these securities traded over-the-counter, it is not without its share of potential problems.

Short selling on the OTC market is extremely risky because these stocks are often very thinly traded, which makes them very illiquid. This illiquidity can prove hazardous if an investor needs to cover an increasingly unprofitable short position. If the volume is very low, covering the position may become a very unlikely prospect.

Another problem that has arisen with short selling in OTC securities is the use of pump and dump schemes. These schemes are done by con artists who use the internet and SPAM emails to heavily promote a thinly traded stock in which they have long positions. When this happens, the result is often a high spike in the price of the stock, followed by a fall. However, the initial spike will devastate any investor with a short position. These schemes often use OTC stocks because they are relatively unknown when compared to exchange traded stocks.

Bottom Line

Although investing in OTC securities seems very simple, they can be riskier than stocks listed on exchanges. OTC stocks are often from companies that are extremely small, with market caps around $50 million or smaller. These companies offer very little information, which may be difficult to find. They are extremely illiquid, and can make it hard to find a buyer.

To learn more, read The OTC Market: An Introduction to Pink Sheets, How to Play the OTC Pink Sheets, and The Lowdown on Penny Stocks.

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