What is Over The Counter (OTC)? Guide To Understanding The OTC Market



Over the counter (OTC) trading is a corner of the investing world that many may find unfamiliar. Yet, the OTC market has been red-hot during the pandemic, witnessing a surge of interest from retail investors as monthly trading volume tops 2 trillion in February 2021 – a 707% increase from the year before.

What is Over the Counter?

Over the Counter (OTC) refers to financial securities that are traded directly between a dealer and a broker as opposed to a centralised exchange such as the Nasdaq or the New York Stock Exchange (NYSE). More than 17,000 securities are traded this way: stocks to derivatives; small/micro-cap companies to international firms. What’s noteworthy is that the notorious CDOs derivatives responsible for the 2007 financial crisis were also traded here in the OTC markets. So were the pink sheets that you might’ve seen in the movie Wolf of Wall Street.

Read Also: 8 Things You Need To Know Before Investing In A SPAC Listing On The Singapore Exchange (SGX)

The majority of OTC stocks are traded on the OTC Markets Group; where they are graded into 3 categories depending on their size, share price, and the amount of financial information they disclose. Investors can scroll to the stock screener page to search for OTC stocks. Here, under the markets tab, we see that there is OTCQX, OTCQB, Pink and more.

Source: OTC Markets

OTC Market Tiers Explained

OTCQX Best Market is the highest tier and only 5% of OTC stocks are traded here. It consists of MNCs, blue-chip stocks and other highly transparent companies that are subject to strict reporting standards and regulatory oversight by US regulators. This tier is intended to identify large, high-quality companies that would qualify to list on a national stock exchange, but do not due to expensive listing costs. For the Nasdaq, the cost is between US$125,000 and US$225,000 annually.

OTCQB Venture Market is the middle tier, designed for early-stage or developing companies and comprises 10% of all OTC stocks. These companies have to be current in their financial reporting, undergo annual verification, and their share price must be above $0.01. Stocks here have a level of stability, but they are still mostly microcap or “penny stocks.”

The lowest tier, OTC Pink (also known as Pink Sheets), is the most unregulated – with firms free to disclose as much or as little information as they desire. The marketplace consists of a wide range of companies including distressed companies, shell companies, and dark companies. There is a high degree of speculation in this marketplace.

Common Types of OTC Stocks

The next tab is the security type, where we see that ADR, common stock and foreign ordinary shares make up the bulk of OTC security types. Besides foreign companies, the OTC market is also well-known for comprising of penny stocks and cannabis firms.

Foreign Stocks

Source: OTC Markets

Many non-US companies trade in the US markets as ADRs (American Depository Receipts) or Foreign Ordinary Shares. ADR are receipts for shares of foreign stock issued by U.S. banks, meaning that an ADR represents shares in a foreign corporation.

For example, DBSDY is the ADR for DBS Bank, which is listed only on the Singapore stock exchange. ADRs were created to overcome the complexities for US investors in buying foreign stocks, where for example: one must exchange USD to SGD, open a local brokerage account, and purchase it on the SGX from 8pm to 4am New York time.

Conversely, with the US market now easily accessible to Singaporeans, ADRs offer us the opportunity to invest in a multitude of global companies, such as Heineken (HEINY), Nestle (NSRGY), and Tencent (TCEHY). You may have noticed that ADR stock symbols are 5 alphabets long and end with ‘Y’.

Foreign companies that do not offer ADR have shares that can be bought as foreign ordinaries by US investors. They are similar to ADRs in that they provide exposure to overseas companies, but there are key differences. Firstly, commissions for trading foreign ordinaries are higher than ADRs: Charles Schwab (a brokerage firm) charges US$50 for foreign ordinaries and US$6.95 for ADRs. Secondly, dividends for foreign ordinaries are paid in foreign currency and will require the investor to convert back, while ADR dividends are paid in USD. Lastly, liquidity volumes for ADRs are usually higher than their foreign ordinaries, resulting in a better bid/ask spread.

Thus whenever possible, it is better for investors to buy ADRs than foreign ordinary shares.

ADRs Foreign Ordinaries

Commissions (by Charles Schwab)

US$6.95 US$50

Dividends

USD

Foreign Currency

Liquidity Varies by ADR

Low

Foreign Financial Taxes Exempt

Not Exempted

Penny Stocks

Penny stocks refer to shares of a company with low market capitalisation trading in the OTC markets, and are defined by their share price being lower than $5 per share. Penny stocks are the starting block for small businesses to access funding from the public in order to drive their growth. For many beginner investors, the low share price of penny stocks suit their small investment capital and offers significant room for share price appreciation as they grow into larger companies. Many large, well-known corporations today were once traded as penny stocks: Ford Motor Company, Monster Beverage, and Blackberry. Investors that bought these stocks would have struck the multi-bagger jackpot. Because of this, penny stocks are known to be highly speculative – either delivering quick, juicy returns or becoming money pits where investors’ monies are lost as the company flounders.

Penny stocks have a notorious reputation for burning investors, due to several properties they exhibit: high price volatility, opaque business model, and low trading volume. Penny stocks are prone to wild fluctuations in prices: an 80% drop within a week is not unheard of, thus investors have to be able to handle such volatility. Penny stocks are usually lesser-known companies with limited press coverage and company information, making investors buy-in blind or research painstakingly. Lastly, thin trading volumes mean there are few buyers which can lead to illiquidity. You may be making profits on paper, but be unable to realise the gains as you can’t sell the stock immediately.

Cannabis Stocks

Cannabis stocks consist of cannabis growers and retailers, cannabis-focused biotechnology companies, and ancillary product providers. With the cannabis industry now booming, pharmaceutical giants have gone on a marijuana acquisition spree and new companies are popping up on OTC markets. As the legalisation of marijuana advances rapidly in the US and around the world, it has fuelled a rally in cannabis stocks. For example, on the heels of legalisation of cannabis in Canada, several weed-growers posted double or triple digit returns for investors.

Some of our local readers might wonder if it is legal for them to invest in cannabis stocks given that cannabis is outlawed in Singapore. To that, the answer is a yes since there are no laws against it.

Cannabis stocks are commonly traded OTC rather than on major exchanges due to two main reasons: lack of revenue/income history and federal laws. One of the criteria to list on the Nasdaq is US$11 million in aggregate three-year pre-tax earnings. Given that the industry is still in its infancy, many companies have yet to turn a profit yet, and are thus ineligible to be listed. The other reason is that the US federal government maintains that marijuana is an illegal substance, though certain states have legalised it. Therefore, the NYSE and Nasdaq do not allow companies that sell marijuanna in the US to list. Interestingly though, it is permissible for companies that sell marijuana outside the US to list. As such, some of the biggest cannabis gainers on the OTC market are those infiltrating US states that recently legalised recreational marijuana.

Risk and Reward of Each Type of OTC Stock

Foreign Stocks

International stocks can be an excellent component in your overall investment portfolio, as growth opportunities are not only limited to the Singapore or the US stock markets. Blue-chip ADRs offer investors a pragmatic choice to ride on the growth of foreign MNCs, tap into the rapid expansion in foreign economies, and diversify from a saturated Singapore or US market. Readers can take a look at JP Morgan’s international portfolio of ADRs or access the screener tool to research more about these stocks.

For the lesser known ADRs and foreign ordinary shares, investors have to be wary of the low trading volume that impacts liquidity. Both instruments are vulnerable to exchange rate risks and country-specific risks such as political regime changes.

Source: Google Finance

The potential payoff of investing in a penny stock that turns into power stock can be huge – just imagine a stock that goes from US$0.59 to US$13.54 in 2 weeks, a 2,194% gain. That has happened to Signal Advance Inc, after it was mistaken for texting app Signal, which Elon Musk had recommended. Though investing in the right penny stock can yield hefty profits, there are plenty of risks. ‘’Pump and dump’’ schemes are common amongst penny stocks as fraudsters would hype up a particular stock and boost its stock price before dumping their shares at this higher price. Acquiring tangible information about penny stocks can also be difficult, especially for those in the Pink Sheets tier as the companies are not required to produce filings. Due to these reasons, many of those that invested in penny stocks have experienced negative returns, according to a white paper by the SEC.

Cannabis Stocks

According to a report by Grand View Research, the global cannabis market is forecasted to grow from US$28.3 billion in 2021 to US$197.7 billion in 2028 – a staggering 32.4% annual growth rate. The tremendous growth for the marijuana industry makes marijuana stocks an intriguing long-term investment. For the first-mover marijuana companies, revenue growth numbers have been outstanding: Green Thumb Industries reported a revenue increase of 167% year over year as the state of Illinois legalised marijuana.

The risks of investing in marijuana stocks are similar to those of penny stocks: low liquidity and lack of company information. Additionally, they face legal and political risks that affect the company’s expansion plans, as well as supply and demand imbalances which affect marijuana pricing.

How to Trade OTC Stocks

Our local brokers do offer OTC stock trading, such as Tiger Brokers, TD Ameritrade, IBKR, Vickers, etc. But some brokers might restrict the trading of certain OTC stocks as they are deemed too risky. OTC stocks are traded at the same time as US stocks, from 9.30pm to 4am Singapore time.

OTC trading (apart from the blue-chip ADRs) might not be for everyone, for they are highly illiquid; frequent targets of market manipulation; and often generate negative investment returns. For a full understanding of the risks involved, investors can look at Tiger Broker’s risk disclosure page. For the conservative investors and the relative novices, starting off from the OTCQX Best Market tier might be a good option. For the risk-takers and more experienced, trading OTC can be a great learning experience.

Read Also: Tiger Brokers App: 5 Useful Features To Help First-Time Singapore Investors And Traders Get Started

Photo by Chris Liverani on Unsplash

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