Understanding the Risks of OTC Stock Trading

The primary risks involved in trading over-the-counter (OTC) stocks are two-fold. One, there is usually a lack of reliable information about the company. Two, OTC shares are commonly exchanged in thinly traded markets.

OTC stocks, often synonymous with penny stocks because many trade for less than $1, can be tempting for investors. OTC stocks allows investors to buy a lot of shares for little money, which could turn into large sums should the company become highly successful. Some OTC companies are touted as offering the next great technology with unlimited upside potential.

However, it is difficult for investors to determine the realistic potential of OTC stocks, due to the lack of readily available information about the companies. Unlike stocks that trade on national exchanges, OTC companies aren't bound by the same disclosure requirements. About all that's required for a company to list on an OTC exchange is the completion of a listing form. A dearth of public information can make it difficult for the average investor to properly evaluate an OTC company.

Other Major Risks

The other major risk in OTC trading is the market for OTC shares are often thinly traded, with wide bid-ask spreads that make it difficult to trade profitably.

For example, an OTC stock might trade for $0.05 per share, but with the bid set at $0.05 and the ask set at $0.10. To get into the stock, an investor would need to pay the asking price of $0.10 per share, and can only exit the position at $0.05 per share. In short, the investment is down 50% as soon as the investor initiates the trade. The stock would need to double for the investor to break even (not accounting for commissions).

Despite the inherent risks, the opportunity to turn a small investment into a potential fortune continues to attract traders to the OTC market.