As you start getting your feet wet in the stock market, you’ll quickly realize that there are various different types of stock in the market.
Not only are there different classifications for stocks in terms of preferred or common stocks and in terms of market capitalization — such as penny stocks and large-cap stocks — stocks are also classified based on the quality of the exchange on which they are listed.
As a beginner investor, you might hear the terms “over-the-counter,” “OTC stocks,” and “OTC markets” from time to time, and understanding what these terms mean and the implications of investing in OTC stocks will save you from increased risk and potentially devastating losses.
What Are Over-the-Counter Stocks?
The term “over-the-counter stock” is used to describe any stock that doesn’t trade on a major stock exchange like the Nasdaq or New York Stock Exchange. These equities are generally either penny stocks or micro-cap stocks and come with an increased level of risk.
When a stock is listed on a major stock exchange, it must meet and maintain stringent listing requirements as well as regulatory reporting requirements. As a result, major exchange-listed stocks offer investors a level of security that the highly unregulated OTC markets simply don’t provide.
Moreover, OTC Markets have become attractive to foreign companies and small companies in recent years by providing these companies a way to tap into United States capital without the high cost of keeping up with regulatory requirements, reporting requirements, and strict listing requirements.
Pro tip: Many online brokers don’t allow you to invest in OTC stocks. One exception is TradeStation. With TradeStation, there is no minimum investment and no trading fees.
In the United States, there are three major OTC markets on which some of the more risky and often more rewarding penny stocks live.
Pricing quotes for these stocks can be found through their exchanges or through Financial Industry Regulatory Authority’s (FINRA) Over-the-Counter Bulletin Board, abbreviated OTC Bulletin Board or OTCBB. These include:
Stocks that trade on OTC Pink, also called pink sheets, are generally the riskiest plays an investor can get involved with. There’s little in terms of regulatory requirements and absolutely nothing in terms of listing requirements.
As a result, this is where you generally find concept companies in the earliest stages that tend to be highly speculative plays.
In many cases, these can be shells or companies with little by way of operating activities. OTC Pink stocks trade under three different classifications:
- OTC Pink Current Information. OTC Pink-listed stocks are not required to file regulatory submissions with the SEC. Those that do provide investors with quarterly and annually audited financial statements are labeled as OTC Pink Current Information stocks. All audited financial reports for these companies are available at the OTC Market Group’s OTC Disclosure & News Service. If you are going to invest in OTC Pink-listed stocks, OTC Pink Current Information stocks are the safest way to go.
- OTC Pink Limited Information. Any OTC Pink-listed company that has provided a quarterly or annual report in the past six months is considered an OTC Pink Limited Information stock. Because financial information is “limited,” these stocks come with an elevated level of risk.
- OTC Pink No Information. Finally, the riskiest OTC Pink-listed stocks are OTC Pink No Information stocks. These companies have not submitted information of any kind over the past six months. This includes financial information provided to the OTC Markets Group or regulatory agencies. Oftentimes, you will find a skull and crossbones icon next to the company’s ticker symbol on OTC Pink No Information stocks. This means that these companies are known to engage in questionable business practices and represent the highest level of risk an investor can undertake.
The OTCQB is the next step up from OTC Pink. Once concept companies gain a little clout and a bit of investor backing, they tend to move up to the OTCQB. While stocks listed on any OTC market come with high levels of risk, OTCQB-listed stocks are generally more trusted than OTC Pink-listed stocks.
These companies regularly file financial information with the SEC or other regulatory agencies. However, there are no financial requirements to be listed on the OTCQB.
As such, stocks listed on this exchange, often considered to be the “middle marketplace” or “venture stage exchange,” come with an increased level of risk when compared to major exchange-listed stocks that must comply with strict financial listing requirements.
Stocks listed on the OTCQB are generally more operational, meaning that they have more in the works by way of research, development, and the commercialization of products than stocks listed on the OTC Pink. However, they tend to be either young companies or companies with some history of significant risk.
Either way, investors should be cautious with OTCQB-listed stocks.
Finally, the most highly regulated OTC exchange in the United States is known as the OTCQX.
However, the requirements to be listed on the OTCQX are nothing compared to the requirements to be listed on formal exchanges like the Nasdaq or New York Stock Exchange (NYSE). The OTCQX is considered the top OTC exchange in the country, listing the strongest and most well-established stocks the OTC markets have to offer.
Companies listed on the OTCQX not only file financial statements with regulatory authorities on a regular basis, but they must also meet financial requirements and be sponsored by a third party accredited investment bank or attorney advisor, affording a level of protection to investors in these stocks.
Pro tip: Before you add any stocks to your portfolio, make sure you’re choosing the best possible companies. Stock screeners like Stock Rover can help you narrow down the choices to companies that meet your individual requirements. Learn more about our favorite stock screeners.
Dangers of Investing in OTC Stocks
Not all OTC stocks are horrible investment opportunities. In fact, some of the biggest companies on the stock market today started their run on the OTC markets.
However, if there’s one lesson you take from this article, it should be that investing in OTC stocks comes with an inflated level of risk. As such, here are the risks associated with these types of investments.
Due to the high-risk nature of investing in OTC stocks, demand for these stocks is quite low compared to demand for major exchange-listed stocks. Therefore, stocks listed on OTC Markets experience far less trading volume than stocks listed on major exchanges.
This creates a serious risk. Should an OTC stock you’re invested in begin to experience significant losses, you may be left holding the bag with nobody to sell the stock to in order to avoid further losses.
OTC market-listed stocks are small companies that are generally micro-cap stocks or penny stocks. These stocks are known for high levels of volatility, increasing the risk of significant losses and making timing entrances and exits difficult.
As small companies in their early stages, OTC stocks aren’t known to represent companies with the best balance sheets. In most cases, these companies are walking a financial tightrope in order to stay afloat.
As a result, to avoid insolvency, OTC stocks often raise capital through dilutive transactions that ultimately rob current investors of share value.
The vast majority of companies listed on OTC markets are in their early stages. Some are even shell companies with little to nothing in terms of operational effort.
Even those that are fully operating and fully reporting are usually either in the process of developing a product or service or just in the beginning stages of selling a product or service and have no real history from which an investor can glean valuable information.
Due to the high volatility and often low share float found in OTC markets, scams and schemes are commonplace on the OTC. One of the most common is known as the pump-and-dump scheme.
Essentially, an investor or group of investors will purchase a large number of shares in a company. That investor then artificially inflates the value of the stock by spreading false or misleading information across the Internet, pumping up demand.
Once the stock reaches its high point, the large investor sells their shares, sending the stock on a dramatic fall and resulting in significant losses for those who bought in on the false or misleading data.
Due to the early stages of operation companies listed on OTC markets are in, investments include high levels of speculation. Essentially, investors are hoping for the best with no real history of strong performance to go off of. This is a risky concept.
The OTC market is a largely unregulated market. Many stocks listed don’t even report financial statements on a regular basis.
In financial markets, where regulation is slim, fraud tends to be rampant. As such, the lack of regulation found in the OTC market sets the stage for serious risks.
Advantages Offered by OTC Markets
OTC stocks aren’t all bad. If they were, nobody would invest in them. Although there are serious risks to consider if you want to invest in companies listed on the OTC markets, there are a few benefits to doing so.
Low Share Prices
Due to the low market caps of OTC-listed companies, OTC-traded stocks tend to come with share prices in the pennies, making access to these stocks simple while risking small amounts of money on what could become large opportunities.
Potential for Momentous Gains
Some of today’s largest companies got their start as publicly traded companies on OTC markets. Although finding these opportunities is like finding a needle in a haystack, with enough due diligence, you could land on a stock worth $0.10 today that could be worth hundreds of dollars several years from now.
Few major exchange-listed stocks offer comparable growth potential.
The Leading Edge of Innovation
Companies that have staked their claim in their markets have already innovated, and although they will work to make their products better, they tend to stay in their lane, sometimes failing to think outside of the box over time. That’s why today’s largest companies likely won’t be the largest companies in the world 30 or 40 years from now.
Purpose-driven companies in early stages, and the management teams that run them, have a drive to succeed that you can only get by being hungry for success. As a result, some of the companies listed on OTC markets just so happen to be some of the most innovative companies in the world.
Who Should Invest In OTC Stocks?
Considering the incredible risks that come along with investments in OTC stocks, they definitely aren’t an option for everyone. In fact, if you’re a beginner or even an intermediate investor with a relatively strong understanding of the market, it’s best to stay away from OTC stocks.
The truth is that experts are the only investors that should consider trading OTC stocks, as investments in this space can lead to significant losses.
How Much of Your Portfolio Should You Allocate to OTC Stocks?
Again, only experts should consider trading OTC stocks. However, human beings often have a driving desire to go against the grain, take a risk, and hope for a reward.
If you have a healthy risk appetite and are dead-set on trying your hand in OTC stocks, you should limit your holdings in these high-risk plays — combined with any other high-risk plays in your portfolio — to a total of 5% of your investing capital.
An Exception: Large Cannabis Stocks
Throughout this article, you’ve learned that OTC-listed stocks are generally risky investment opportunities that only expert investors should consider. However, there are several well-established cannabis stocks listed on OTC markets that act as an exception to the rule.
Although cannabis is legal in various regions across the United States, the regulatory reform of cannabis in the U.S. has been limited to the state level. Cannabis is still an illegal controlled substance on a federal level. Companies that engage in illegal activities — whether their state allows them to or not — cannot be listed on major exchanges in the United States.
As a result, there are large cannabis companies such as Trulieve Cannabis, Charlotte’s Web, and Cresco Labs that trade on OTC markets even though their market caps are more than $3 billion, more than $810 million, and nearly $2 billion, respectively.
Two of these stocks trade in the large-cap range while one trades in the mid-cap range, and they all generate revenue, have strong balance sheets, and report financial statements regularly.
As a result, if you’re looking into cannabis stocks, you may find that even some of the most trusted in the space are traded on OTC markets. This is the one time when the fact that the stock is OTC-listed should not steer you away from investing.
Note: Although some cannabis companies are listed on major exchanges, these are foreign companies doing business in countries where cannabis is legal, such as Canada. Therefore, these companies are not breaking any federal laws and can be listed on U.S. exchanges.
Beginner and intermediate-level investors are often lured into OTC stocks by the promise of massive gains over a short period of time. However, when investing in the stock market, where there is potential for dramatic gains, there’s also generally the potential for significant losses.
When it comes to OTC stocks, if you’re not digging into a well-established U.S. cannabis company, chances are you should turn the page to the next opportunity.