Risks of Trading OTC Stocks

Written by john landers
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The risks of trading over-the-counter (OTC) stocks must be seriously pondered by traders who are considering investing in these assets. Often, the probability of suffering a loss on a trade is higher than the probability of making a profit. Although many legitimate companies trade OTC, the market for these stocks is associated with uncertainty and sometimes fraud, the primary reason being that OTC stocks are typically not listed or traded on any of the major stock exchanges, which are more thoroughly regulated. Over-the counter stocks are usually traded by broker-dealers, market makers who basically do business over the phone and by computer.

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Definition

Generally, stocks not listed on the NASDAQ, New York Stock Exchange (NYSE) or NYSE Amex Equities (formerly called the American Stock Exchange,) are considered to be OTC stocks. Many of these stocks are also known as "micro stocks," or "penny stocks." They are the issues of small firms or new companies that are not established enough to meet the requirements to be listed on the major stock exchanges. Some may have even been "de-listed" because they dropped below the minimum stock price required for listing.

Company Data Elusive

One of the major risks of trading OTC stocks is the fact that there is often a lack of information available on issues. Although a daily list of available OTC stocks is available in print, only brokerage houses have access to the information. This list is called a "pink sheet." Unlike larger and more reputable companies, many firms issuing OTC stocks do not make financial reports, such as quarterly and annual statements, available to the general public. Although advances in information technology and tracking techniques have made more information available, a dearth of financial details and other data on companies' operating history remains. This makes investing in these stocks more of a gamble than traditional issues.

Prices Can Be Misleading

The price and volume information for stocks traded on the major exchanges, and some OTC stocks, is frequently collected and made available to the investing community. However, the same data are typically not accessible for most OTC stocks. Usually, brokerage houses that trade OTC stocks will offer information regarding trades they consummate. The result is that most investors cannot be confident that they are receiving the best price for the issue. Generally, brokers will quote the actual price of a stock and a separate price for commission. In contrast, the price of an OTC stock may be marked up by OTC brokers, with commissions built into the price. As a result, the buyer does not get an accurate account of the value of the stock.

Buy Carefully

Buyers must be aware of the bid and ask price, as well as the number of shares that can be purchased at the quoted price. For example, a buyer may submit an order for 2,000 shares of a particular company, and the ask price is 10 cents for the first 1,000 shares. The next batch of 1,000 shares may have an ask price of 15 cents. So the investor could end up paying an additional £32 ($250 instead of £130) because of his lack of information regarding the number of shares that could be purchased at certain price points. Something else investors must take into account regarding the risks of trading OTC stocks is the peril of split orders. Sometimes large orders must be divided up in order for the broker to execute the client's order. Because two trades were necessary to execute the order, the buyer ends up paying two separate commissions.

Manipulation

Because many OTC stocks are bought and sold by one broker or a small group of brokers, the risk of price manipulation is greater. Some brokerage firms may buy a large volume of OTC stocks at a low price. They then exert undue influence on the price by engineering a false demand for the stock. This usually drives up the price. Therefore, the stock's price does not reflect the real value of the issue. Often, the price of the stock will drop as the manipulators sell off their shares to unwitting investors.

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