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What are the risks involved in OTC (over-the-counter) trading?

Modified on: 2018/07/11
A:

The primary risks involved in trading over-the-counter (OTC) stocks stem from lack of reliable information and the fact that OTC stocks are commonly very thinly traded markets.

OTC stocks, also known as "penny stocks" due to the fact that many of them trade for less than $1, are a tempting opportunity for investors. They offer the chance to buy lots of shares for a little bit of money, which could turn into a lot of money if the company turns out to be highly successful. Many OTC-listed companies are touted as offering the next great technology with unlimited upside potential. However, it's very difficult for investors to determine the realistic potential of OTC stocks; there is usually very little information readily available. Unlike companies that are traded on regular stock exchanges, OTC companies aren't required to provide a lot of information. About all that's required for a company to be listed on the OTC exchange is filling out a form requesting to be listed. This can make it very difficult for the average investor to obtain sufficient information to make an informed investment decision regarding a company.

The other major risk in OTC trading is that the market for an OTC-listed stock may be very thinly traded, with extremely large bid-ask spreads that make it very difficult to trade profitably. For example, a stock may be trading for 5 cents a share, but with the bid-ask spread being 5 cents bid at 10 cents. To purchase the stock, an investor has to pay the asking price of 10 cents per share for a stock that he or she can only sell for 5 cents per share. In short, the investment is down 50% in value as soon as the investor initiates the trade. The stock has to double in price for the investor to be just barely breaking even.

Despite the inherent risks, the opportunity to turn a small investment into a potential fortune continues to attract traders to the OTC market.


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