Spark Global Limited Reports:
If you’re a day trader who doesn’t mind risk, you might find yourself interested in penny stocks.
The potential for big returns comes with a lot of risk.
One reason they are considered risky investments is that, in most cases, they are traded in the over-the-counter (OTC) market. That means the companies are often unprofitable and too small to list on big exchanges such as the New York Stock Exchange or NASDAQ.
In this guide, we’ll introduce penny stocks and delve into more details about otc markets to help you better understand why these markets carry more risk.
What does the term penny stock mean?
Penny stocks, despite their name, sometimes change hands for more than a dollar. In fact, the SEC defines a penny stock as any security issued by a small company that trades for less than $5 a share.
Yet the core idea of penny stocks is that they are the smallest companies, a backwater in the stock market. While some stocks listed on nasdaq or the New York Stock Exchange meet the SEC’s definition of a penny stock, the vast majority of stocks are traded over-the-counter.
What is the OTC market?
An over-the-counter (OTC) market is an electronic network that allows two traders to trade stocks through a broker acting as an intermediary. The otc market is called dealer market or dealer network.
By contrast, major stock exchanges such as the New York Stock Exchange or NASDAQ are auction markets. The price of a stock is published (” asked “), and then traders bid on it, bidding against each other.
While otc companies are treated as public companies, they are not. That means their shares can be sold or bought publicly, but they are not listed on a formal exchange.
As a result, these stocks are not subject to the requirements and rules that major exchanges impose on their listed companies. In other words, there is no regulatory focus on over-the-counter stocks.
In short, the OTC market is a wild West arena, with just about everything and no listing requirements.
How does the OTC market work
In otc markets, stocks are traded by phone, fax, email or between individuals, without a central trading venue for all traders.
The companies that trade on these markets are usually very small, or those that are just starting up, meaning their shares cannot be listed on a formal stock exchange.
It is important to note, however, that over-the-counter trading does not mean that a company is unstable or unworthy to list on a major exchange.
Many profitable companies may not be able to list on NASDAQ or NYSE because they are not old enough, have a free float or have high enough revenue.
In these markets, you are also likely to find shares in some of the best-known multinational conglomerates. Similarly, otc traders have gone from novice to veteran. In addition to trading stocks over the counter, traders can buy and sell commodities, bonds and derivatives.
Why are over-the-counter markets riskier than listed exchanges?
As we mentioned earlier, companies whose shares trade over the counter are not regulated. Unlike companies listed on the Nyse or NASDAQ exchanges, otc companies are not obligated to meet quarterly reporting requirements or any specific compliance requirements.
So, like buying a used car, traders can only trust whatever information is presented to them, making over-the-counter stocks risky securities.
In addition, because of less stringent reporting requirements for stocks listed on otc markets, fraud is more likely to occur when trading on the market than on major exchanges.