Securities trading can be done outside of regulated exchanges and this was the norm before the widespread adoption of exchanges. Trades on these person-to-person markets do not generate high volumes and are more volatile than trades made on an exchange. In addition, the Forex market is an Over The Counter Market, whereas stock trading is centralized.
OTC definition
OTC, or over-the-counter, refers to trading activity done without a centralized exchange. The trades are done between broker-dealers and traders. The Forex market is an OTC market.
OTC markets still adhere to some regulation, albeit, much less than traditional exchanges.
Some companies that do not have the means of going through the regulatory barriers of entry to the stock markets can trade their shares over the counter.
Why it is important for traders to understand OTC trading
- OTC trades have lower volumes and are more volatile toward large-volume trades
- OTC markets are subject to less regulation and can be risky due to lax reporting requirements
- OTC trades have higher spreads and can be fairly difficult to liquidate
- Different assets, such as penny stocks, derivatives, bonds, and ADRs are traded over the counter
OTC trading in more detail
OTC markets are a cheaper and less regulated alternative to major exchanges. Companies that cannot meet the stringent requirements to acquire a listing tend to prefer OTC markets.
Stocks are not the only asset class tradable over the counter. Derivatives and bonds are also frequently available to OTC traders.
The main focus of OTC traders is to find undervalued assets, such as stocks, that have the potential to increase in price in the short-term.
However, the low regulatory requirements also mean that some of the issuing companies do not report their financials on a regular basis.
This can be risky, as low liquidity makes OTC trades hard to exit without incurring losses.
The OTC dealer facilitating the trade might not have the longest performance record – adding to the risk.
OTC market example
Securities that do not meet the criteria provided by exchanges are sold over the counter. Some of the assets frequently traded OTC are ADR and penny stocks. ADRs are depositary receipts that are held in the name of a foreign company selling their shares without a direct listing. Penny stocks are low-cap stocks of companies that cannot acquire a direct listing, or choose not to as a cost-saving measure.
OTC market performance is tracked by indices which can be highly volatile as penny stocks, and pink sheets in particular, are prone to sudden price movements upon economic new updates.
The largest OTC marketplace in the US is operated by the OTC Markets Group (OTCQX:OTCM).
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FAQs on OTC markets
What is traded on OTC markets?
Stocks, ADRs, pink sheets, derivatives and bonds are among the most frequently traded products on OTC markets. The low listing costs and less regulatory oversight is favorable for many issuing parties.
Is OTC trading safe?
OTC trading is less regulated than stock exchanges. Issuing companies might not post financial updates regularly, which can be a problem for traders. The low liquidity levels also make OTC trades highly volatile.