If you are a day trader who doesn’t mind risk, you may find yourself interested in penny stocks.
These stocks have great potential for returns, but they also carry great risks.
One of the reasons they are regarded as venture capital is that, in most cases, they are Over-the-counter (OTC) market. This means that they are companies that are generally unprofitable and too small to be listed on major exchanges such as the New York Stock Exchange (NYSE) or Nasdaq.
In this guide, we will study low-priced stocks and delve into more details of the over-the-counter market to help you better understand why these markets are more risky.
What does the term “you get what you pay for” mean?
Despite their names, Low-priced stocks Sometimes it changes hands for more than one dollar. In fact, the U.S. Securities and Exchange Commission (SEC) Define a penny stock As any security issued by a small company that trades for less than $5 per share.
However, the core idea of penny stocks is that they are the smallest company and the stagnant water in the stock market. Although some stocks listed on the Nasdaq or the New York Stock Exchange meet the definition of low-priced stocks by the US Securities and Exchange Commission, the vast majority of stocks are traded over the counter.
What is the over-the-counter (OTC) market?
The over-the-counter (OTC) market is an electronic network that allows two traders to trade stocks with each other using a dealer broker who acts as an intermediary. The over-the-counter market is called the dealer market or network.
In contrast, major stock exchanges such as the New York Stock Exchange or Nasdaq are auction markets. The price of the stock is announced (“ask price”), and then traders provide it with a quotation and bid against each other.
Although companies that conduct over-the-counter transactions are considered listed companies, they are not listed. This means that their shares can be traded publicly, but they are not listed on official exchanges.
Therefore, these stocks are not subject to the requirements and rules of major exchanges on their listed companies. In other words, no regulatory agency pays attention to over-the-counter stocks.
In short, the over-the-counter market is like a wild west arena, with almost everything and no listing requirements.
How the over-the-counter market works
In the over-the-counter market, stock trading is carried out by telephone, fax, e-mail or face-to-face between individuals, and all traders do not have a central trading place.
Companies that trade on these markets are usually very small companies or start-up companies, which means that their stocks cannot be listed on official stock exchanges.
However, it needs to be pointed out that the OTC status does not mean that the company is unstable or unworthy of listing on major exchanges.
Many profitable companies may not be eligible to be listed on the Nasdaq or the New York Stock Exchange because they do not have enough years of operation to qualify, do not have enough issued shares or high enough income.
You may also find the stocks of well-known multinational corporate groups in these markets. Likewise, OTC traders range from new traders to experienced traders. In addition to trading stocks over the counter, traders can also buy and sell commodities, bonds and derivatives.
Why is the OTC market more risky than the listed exchange?
As we mentioned before, companies that trade over the counter are not regulated. Unlike companies listed on the New York Stock Exchange or Nasdaq, over-the-counter companies are not obligated to meet quarterly reporting requirements or any specific compliance rules.
Therefore, just like buying a used car, traders can only trust any information provided to them, making OTC stocks a risky security.
In addition, since the reporting requirements for stocks listed on the over-the-counter market are not so strict, fraud is more likely to occur in the market than when you trade stocks listed on major exchanges.
Why new traders should avoid the over-the-counter market
The main reasons why new traders should avoid over-the-counter markets are:
Lack of transparency
The reporting standards for companies whose shares are traded on the over-the-counter market are much stricter. This results in stocks that are more opaque than stocks that traders are accustomed to trading on the exchange.
Less verifiable and publicly available information means that over-the-counter companies have the incentive to change the rules for their own benefit as much as possible, and determining the right price can be much more difficult.
This puts OTC traders at risk of relying on false information or making wrong decisions.
Large spreads, low trading volume
For over-the-counter penny stocks, compared with listed stocks, the trading volume tends to be less competitive and much lighter. With this, traders also tend to experience larger spreads.
This makes it more difficult to get a cover at a good price, and if you have any size, it may be difficult to get rid of positions that can cause huge losses.
Small transactions in the over-the-counter market require extra care when entering orders, and you should stay away from market orders at all costs.
Low market value
Stocks traded on the over-the-counter market are more susceptible to skyrocketing plans and manipulation attempts. This is because the value of the company that provides them is much lower.
The market value of stocks traded on the New York Stock Exchange and Nasdaq is so large that few traders can have a significant impact on the price of stocks.
In contrast, the over-the-counter market has many stocks whose prices have changed significantly from relatively small trading volumes. This means that any trader with a large account can manipulate prices.
A kind Extraction scheme This happens when a trader or group of traders artificially inflate the price of a given stock. They already have huge positions, and they can move stocks fairly easily by promoting them on social media sites and message boards.
This has caused many traders to keep up with the trend, and it also provides sufficient liquidity for the original buyer to sell the stock at a higher price (sell). The stock price usually falls thereafter, causing heavy losses to unsuspecting buyers.
Although over-the-counter markets attract day traders who want to trade low-priced stocks, the stocks in these markets should be considered highly speculative.
According to the US Securities and Exchange Commission, “academic research has found that over-the-counter stocks are often:
- Highly lack of liquidity
- Is a common target for suspected market manipulation
- Generate negative and fluctuating investment returns on average
- Rarely grow into a large company or transition to a stock exchange listing
There are many cases where companies mislead traders with improper business transactions and false information in the over-the-counter market.
You really can’t believe any press releases issued by the company on OTC.
Therefore, avoid using over-the-counter penny stocks as a key component of your portfolio and stick to stocks listed on well-regulated exchanges.
In addition, be sure to visit Financial Industry Regulatory Authority website Research and prepare the low-priced stocks you wish to trade on the over-the-counter market.