The OTC Market

The over-the-counter market, or OTC market, includes securities known as “unlisted stock.” This unlisted designation means these stocks are not traded on the traditional stock exchanges like the NYSE or NASDAQ. Instead, securities bought and sold on the OTC are traded by individual broker-dealers, professionals who deal directly with each other via the Internet or by phone.

Buying OTC stocks is very different than buying stocks traded on the major exchanges, in that there is no central exchange for them where buyers and sellers are matched up. Rather, you can only get shares through a market maker, who must actually keep an inventory of shares for sale.

To buy OTC shares, you typically must enlist the services of a broker who is willing to work with the OTC market, and not all of them will. Then your broker has to contact the market maker for the security you want to buy. The market maker will name his ask price, which is the amount he’s willing to accept for the shares. To sell OTC shares, the process works the same way: Your broker would contact the market maker to learn his bid (or offering) price. Bid and ask quotes appear on the OTCBB, the Over-the-Counter Bulletin Board, so that investors can monitor them.

The process seems simple, but it’s fraught with risk. Companies traded on the OTC market are usually too small to be listed on a formal exchange, and reliable information about them can be very hard to find. On top of that, OTC shares are not liquid, so it may be very hard to sell them when you’re ready to do so.

Over-the-Counter Bulletin Board

The OTCBB, or Over-the-Counter Bulletin Board, lists OTC securities that don’t quite make the cut for inclusion on a major exchange due to their listing requirements. On the OTCBB, there are no listing requirements except one: Companies listed on the OTCBB must be registered with the SEC, and thus be subject to its reporting requirements. Corporations that are late with SEC filings can be kicked off of this exchange, and moved down to the pink sheets, an unregulated electronic OTC market. If they catch up and remain current, they can come back to the OTCBB.

Owned and operated by NASDAQ, the OTCBB is a fully electronic system with real-time quotes, the most current pricing information, and the most current trading volume for all of the OTC stocks. Keep in mind that the most current information is based on the last time the stock was traded, which may have been a while ago. Securities listed here have the suffix “OB” attached to their ticker symbols, making it clear that they are only traded over the counter. Technically, the stocks here are quoted, not listed; the term “listed” implies that a security trades on a major exchange.

Part of NASDAQ But Not NASDAQ

The OTCBB is owned and run by NASDAQ, but it is not part of the NASDAQ exchange. In other words, shares listed on OTCBB are not listed on NASDAQ. Unscrupulous market makers may not make that distinction clear, and use the NASDAQ name to make an investor feel more secure about a stock he’s thinking of buying.

“Buying stocks listed on the OTCBB is inherently more risky than buying stocks quoted on the major exchanges for two very important reasons:

  1. This is a much smaller market, and is therefore less liquid. In practical terms, this means investors may have a very hard time selling these stocks.
  2. Because of the low liquidity, stocks trading over the OTCBB have much larger bid/ask spreads, which eats into investors’ returns.

From the investor’s perspective, buying stocks that trade on the OTCBB is like any other stock purchase: You simply call your broker and tell him what you want to buy. From there, the broker contacts the market maker, who quotes the current ask. If you’ve placed a market order (an immediate order filled at the current price), that ask will be the price for the stock you’re buying, and the trade will go through right away. Because this is such a thinly traded market, consider using limit orders (a special order to be filled at a predetermined price) when trading here, because they offer at least some built-in price protection.

Pink Sheets

To be listed on the pink sheets, an unregulated offshoot of the OTC market, all a company has to do is fill out a form (Form 211, to be specific) and file it with the OTC Compliance Unit. All the form asks for is some current financial information, supplied by the company. That’s it.

There are only a few reasons why a company would be traded here:

  • The company is very small and can’t afford to be listed on a more prestigious exchange.
  • The company has been kicked off a major exchange due to noncompliance.
  • The company isn’t real, and its shares are part of a money-making scam.

Some companies give their market maker access to more detailed financial information, including open access to their accounting books. That makes it easier for the market maker to figure out the right stock price. But since corporations are not required to do that, many of them don’t. They don’t have to share any information with potential investors, and they also do not have to file any reports with the SEC, and so investors will have a hard time getting reliable or verifiable information before investing.

Ticker Trivia

“Pink sheets” are so called because the trading information used to be printed on pink paper.

On top of that, companies trading over the pink sheets are usually very small, and their shares are typically held by only a few people. With such a limited market, it can be very hard for investors to sell their shares when they want to.

So what makes pink sheets stock attractive to investors? For one thing, share prices are usually very low, often less than $1. With that minimal per-share cost, even tiny movements in price can bring sizeable returns. For example, say you buy 100 shares of stock in Tiny ABC Inc. for $1 per share, a total investment of $100. A few weeks later, the stock goes up by five cents a share, making your investment worth $105 now. That’s a 5% return on your investment. The same price movement on a more expensive stock, say one trading for $10 per share, would be barely noticeable.

Delisted Companies Land Here

When a company gets kicked off of a major exchange (like the NYSE), a process known as delisting, it lands on the pink sheets. This happens when the corporation no longer meets the minimum listing requirements, often as a result of an unfortunate financial event that endangers the company’s future. Investors who think the company will turn around can scoop up shares on the pink sheets, often at a fraction of its original listed share price.

The real attraction to pink sheet stocks is possibility—the chance that a tiny company will hit it big. In this age of innovation, where the next major breakthrough could come from one guy with a laptop working from his garage, the prospect of getting in on the ground floor of a future Twitter, Amazon.com, or the next big thing is very enticing. Even if the pink list stock never makes it onto a major exchange, it still has the potential to bring enormous returns due to the small initial investment.

Fairly recently, a tiered system was added to the pink sheets trading world to give investors a better idea of just how risky a potential investment may be. The five tiers are aptly named, giving investors crucial information with just a glance.

  1. The trusted tier contains companies considered trustworthy. These companies adhere to listing guidelines and provide investors with information, and may even report to the SEC.
  2. The transparent tier includes companies also listed on the OTCBB, which requires regular and current reporting to either the OTC Disclosure and News Service or the SEC. This reporting allows investors to see what’s going on with the companies.
  3. The distressed tier includes companies that aren’t quite so forthcoming with current information or have declared bankruptcy.
  4. The dark/defunct tier contains companies that either haven’t filed any information within the past six months (indicated by a stop sign symbol) or gray market companies, which have no market maker and are not quoted on either the OTCBB or the pink sheets (indicated by an exclamation point).
  5. The toxic tier comes with a skull-and-crossbones warning to indicate securities that have been marked as suspicious. Some may not even be real companies.

Investors who have the stomach for stocks traded on the pink sheets may need to find a willing broker; not all brokers are agreeable to helping clients buy these high-risk securities. Many of these companies are earnestly trying to grow their businesses and will happily share information with agencies and investors alike. But others are flat-out scams, so beware.