Since the COVID-19 pandemic started, stock market democratization has led to a boom in retail investors entering the market. Currently, in the U.S. market, retail investors account for nearly as much trading volume as mutual and hedge funds combined. The growth is causing a shift in the market, including a rise in OTC (over-the-counter) stock trading.
With OTC stock trading up, the question of risk comes into play. Why is the OTC market more volatile than primary exchanges like the NYSE and Nasdaq? How can investors mitigate that risk?
What are OTC stocks?
The OTC Markets Group is a dealer network that trades OTC stocks. It isn't a central exchange. U.S. and foreign companies can trade over the counter.
The NYSE and Nasdaq subject listings to certain requirements (including SEC filing and minimum stock price requirements). The OTC market doesn't have the same rules, which is why you'll find so many penny stocks there.
OTC stock trading is on the rise
The trading volume for OTC stocks is at $552 billion YTD. That's already more than the $445 billion investors traded all last year, and we're only at the start of the fourth quarter.
Brand names like Volkswagen (OTC:VWAGY), Panasonic (PCRFY), and Nintendo (NTDOY) all trade on the OTC market. So do little-known companies like Blue Sphere (BLSP), Regen Biopharma (RGBP), and Dark Pulse (DPLS).
How the nature of OTC stocks embeds more risk
Because of the lack of rules and regulations, OTC stocks tend to be riskier as a whole than stocks traded on central exchanges. Also, OTC investors are sometimes victims of pump and dump schemes. FINRA says, "Most stock pump-and-dump schemes involve low-priced, thinly traded stocks. [...] These stocks tend to be quoted on an over-the-counter (OTC) quotation platform."
While OTC stocks as a whole are risky, there are truly undervalued companies on the exchange. For investors, it's just about doing the research, digging through the financials, and finding out which tickers are worth the trade.
Exceptions to the rule
Like always in investing, there are exceptions to the rule. The most obvious one is marijuana stocks. Marijuana is still federally illegal in the U.S. and listed as a Schedule I drug under the Controlled Substances Act. However, marijuana companies can legally operate at a state level. Most of them have to do so with cash because banks won't get involved in the industry.
Because marijuana is federally illegal, U.S. marijuana companies who want to go public must do so in two ways:
List on a foreign exchange, usually in Canada on the TSX (Toronto Stock Exchange)
List on the OTC Markets
A company may list in one or both locations.
Want to know the best part? Marijuana is federally legal in Canada, which means that Canadian marijuana businesses can publicly list on a central U.S. exchange. That's definitely ironic.
How to mitigate risk in OTC stock investments
If you want to get involved with OTC securities, consider reserving a limited portion of your portfolio for OTC stock trading. Cap it at 3 percent–5 percent to start. More than anything, do your research so you don't succumb to a scam or bear run.