How to Navigate OTC Trading

For traders looking for opportunities off the beaten path, over-the-counter (OTC) stocks—which trade outside the centralized exchanges—could seem like a tempting opportunity. After all, owning a piece of the next Apple, one of the most successful OTC stocks in U.S. history, is a dream for many investors.

But much of what makes OTC trading appealing also makes it risky. Here's what to consider before you jump in—and how to adjust your trading plan to accommodate the increased risk.

Most trading in the U.S. happens on centralized exchanges, including the New York Stock Exchange and Nasdaq, where member companies must meet certain listing requirements—such as minimums for market capitalization and share price—as well as complex reporting rules mandated by the Securities and Exchange Commission (SEC). In addition, the exchanges provide a structure to communicate information about trades and enforce their rules governing trading.

OTC transactions, on the other hand, take place via a network of broker-dealers that buy and sell shares of a stock directly from one another. OTC Markets Group, which facilitates most OTC trades in the U.S., organizes securities into three over-the-counter markets, depending on the quantity and quality of information the companies disclose:

1. OTCQX^® Best Market: The companies found here are considered the most established and reputable in the OTC market. They must meet certain reporting obligations, follow corporate governance best practices, demonstrate compliance with U.S. securities laws, remain current on all regulatory disclosures, and maintain audited financial records.
2. OTCQB^® Venture Market: OTCQB-listed companies are in the early stages of development and, as such, have fewer requirements. Still, they must be current in their regulatory reporting, maintain audited financial records, and have a minimum bid price of $0.01.
3. Pink^® Open Market: This market has no minimum financial standards. This is where you'll often find shell companies, companies going through bankruptcy, and foreign companies that don't want to disclose certain financial information. Firms in this market are classified as "Current Information" (current in their reporting to a regulating body), "Limited Information" (delinquent in their reporting for less than six months), or "No Information" (delinquent in their reporting for six months or more).

Even companies listed on OTCQX, which has far higher standards than OTCQB and Pink, are substantially riskier than those listed on centralized exchanges—for five primary reasons:

• Limited oversight: When an OTC-listed company fails to comply with market rules, it isn't delisted like it would be if it traded on a centralized exchange; rather, the OTC Markets Group can only flag a stock as suspect and report it to the SEC.
• Lack of transparency: It can be difficult to find reliable information on OTC stocks, leaving investors more vulnerable to fraud and inappropriately valued equities, especially since broker-dealers determine pricing rather than using the real-time price of a centralized exchange.
• Lack of liquidity: Many OTC stocks are so thinly traded they can be hard to sell when you want—never mind at your desired price.
• Potentially higher volatility: Because OTC stocks trade in relatively small amounts, a single purchase or sale can result in dramatic price moves.
• Lack of downside protection: Stop-loss orders—which can automatically close out losing positions before they become even bigger losers—aren't available for OTC trading.

While there are traders who flourish in OTC markets, they're a rare breed. I myself have adopted three guiding principles when it comes to my own OTC trading:

1. Prioritize quality: U.S. companies that trade over the counter tend to fall into one of two groups: existing businesses experiencing a financial setback or new companies looking for growth capital. Either way, I favor the OTCQX market because of its higher reporting standards.
2. Favor big foreign firms: Some well-established international companies make their shares available on OTC markets to reduce their regulatory burden. Be that as it may, they must often adhere to rigorous reporting requirements in their home countries, so I use that information to help steer my trading decisions.
3. Go small: Given the highly speculative nature of most OTC stocks, you'll naturally want to limit your exposure to what you can afford to lose. Even so, I tend to limit my own OTC positions to no more than 1% of my total trading assets.