The Inherent Risks of the OTC Markets

Risk is an essential part of investing, so therefore, it is a necessary part of day trading. You cannot have opportunity without risk. But the key to be a successful trader is to be able to discern between reasonable risk and unnecessary risk. That is why it makes sense to avoid OTC markets as a trader before you are experienced and savvy enough to handle them.

Let’s define OTC markets. Over the counter markets are exchanges or places where small-cap stocks are traded, without the same oversight and disclosure requirements of companies that trade on the NYSE or the NASDAQ. The risks are higher because it is harder to get good, reliable information about the companies. The potential for scams is there. So you need to be a seasoned day trader before you begin to consider OTC markets.

There are profits to be had when you are trading in OTC markets. But the volatility is greater and the quality information more scarce, so it is just harder to really limit your risk. Not impossible, but harder than the regular exchanges. And the process of buying stocks on the OTC market is very different from the major exchanges. When you buy a stock that is over the counter, it is sold by a market maker, or a company that keeps inventories of stocks on hand for the purposes of reselling them.

You can still buy these OTC stocks through a brokerage firm. But the key is you have to find a broker that you trust that will deal in the OTC markets. Not all brokers are set up that way. Some prefer to avoid OTC markets all together. There is a very good reason for this. The broker can be stuck brokering a very delicate exchange.

If you want to buy an OTC stock, you put in a market buy order with a broker. The broker then has to go to the market maker and request to buy that stock. The broker has to accept whatever price the market maker quotes, because the order was to buy the stock at market price. And market price is whatever the market maker says it is. As an investor or trader, you can put a limit order or stop order on the OTC stocks in order to keep a reasonable price limit. But there is no guarantee that the broker will find the right price.

OTC markets tend to work with companies that have a very small market cap, usually $50 million or below. The lack of information, as stated above, is not great for traders. It can create advantages for market makers and others in the know. Trading of stocks is always about information. The more info you have and the better quality of info, the better able you are to make decisions about what to buy.

You might have heard of the pink sheets. These are the colloquial names for the OTC markets. In the early days, the stocks used to be listed on actual pink sheets. These days it is all electronic. The pink sheets are where OTC markets are really housed. There is no trading floor. And there is much more opportunity for fraud and stock price manipulation.

Avoid the OTC markets until you have enough hours of screentime to know what you are doing. Risk is always something to be handled carefully.

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