OTC markets are popular among traders looking for penny stocks and microcap stocks that don’t trade on the major exchanges. However, these markets lack some of the safeguards of stock exchanges and OTC stocks often don’t have the same level of regulatory scrutiny as exchange-traded stocks.

So, it’s important to understand how OTC markets work, what the different OTC market tiers are, and what the classifications that are given to OTC stocks mean.

What are the OTC Markets?

OTC, or over-the-counter, markets are decentralized stock markets where individuals buy and sell stocks directly with each other. Typically, the term OTC markets refers to the specific decentralized markets run by The OTC Markets Group, a for-profit financial markets provider.

OTC markets are typically home to penny stocks and micro-cap stocks that don’t meet the stringent listing requirements of major US exchanges. Some well-known foreign companies, like Nestle, Volkswagen, and Samsung, also trade on OTC markets in order to avoid costly US exchange regulations.

OTC Markets vs. Other Exchanges

OTC markets operate very differently from other exchanges. First, they are fully electronic and do not have physical locations. Buy and sell orders are matched automatically or by dealers, and the prices at which transactions occur are not always visible to everyone in the market.

As a result of this system, liquidity is frequently low in OTC markets. Prices can swing wildly throughout the day, particularly compared to major exchanges. Particularly for penny stocks, it can be difficult to enter or exit positions quickly.

Another important difference between OTC markets and other exchanges is in how they are regulated. OTC markets are subject to much less oversight by the SEC than major exchanges, and there are fewer rules around what information companies must report. It’s critical that you do your own research when buying stocks on OTC markets, especially since some smaller companies have been known to exaggerate or misstate financial information for investors.

OTC Market Tiers

The OTC Markets Group platform is divided into three distinct marketplaces: OTCQX, OTCQB, and OTC Pink.

OTCQX

The OTCQX market has the strictest regulatory and reporting requirements of the three OTC market tiers. In order to list on this marketplace, companies must report to the SEC, disclose material news to investors, and be sponsored by a third-party such as a bank or investment firm. In addition, companies on the OTCQX market must meet revenue, stock price, and market cap minimums.

Given these stringent requirements, stocks on the OTCQX markets are considered more trustworthy and typically have more liquidity than those on the lower market tiers. 

OTCQB

The OTCQB market is a step down from the OTCQX market in terms of what is required of companies in order to list shares. Companies must be audited annually, report to the SEC or a banking regulator, and must have a minimum share price of $0.01. These companies must also have a float of at least 10% of outstanding shares.

This marketplace includes many companies that are growing and need access to public markets for capital, but don’t yet have the capacity to meet the reporting or revenue requirements of the OTCQX marketplace.

OTC Pink

The OTC Pink market, also known as the ‘Pink Sheets,’ is the least regulated OTC market. Companies on the OTC Pink market do not have to be audited, although they must report to the SEC. They must also file a form with FINRA in order to list.

Companies on the OTC Pink marketplace are often penny stocks, shell companies, and companies that are in financial distress. Be cautious of scams when trading stocks in this market.

Other OTC Market Classifications

Stocks on the three OTC market tiers are classified in several additional ways that indicate their current status or to provide warnings to potential investors. Typically, these classifications are visibly listed on The OTC Markets Group page for a particular stock.

Delinquent SEC Reporting

A delinquent SEC reporting classification indicates that a company is not up to date with its SEC reporting requirements under the Exchange Act. Companies that are delinquent may be subject to removal from the OTC markets by the SEC until reporting requirements are fulfilled. In other words, a company that falls behind on its reporting may have trading of its shares suspended.

Shell Risk

The OTC Markets Group may classify a company as a Shell Risk if the company has financial or other characteristics of a shell company. This classification is assigned subjectively based on a company’s financial disclosures and is not based on companies’ self-reported shell status. Shell companies can be problematic for investors because they hide the underlying company’s financial activity and changes in operations.

Dark or Defunct

Companies labeled as Dark or Defunct are those that have failed to provide any public financial updates, either to the SEC or to The OTC Markets Group.

Caveat Emptor

The Caveat Emptor classification is a public warning to investors issued by The OTC Markets Group. This designation indicates that the company has been associated with fraudulent or potentially illegal activity or has a pending suspension of trading by regulators. 

Conclusion

The OTC markets are where the shares of thousands of startups, micro-cap companies, and foreign companies trade. Understanding the three different OTC market tiers can help you evaluate the risk of a particular stock and gauge the stock’s regulatory oversight and liquidity. When trading stocks on the OTC market, be sure to look for classifications by The OTC Markets Group that may provide additional information about a company’s regulatory status.

Market makers play a key role in facilitating the stock exchange as we know it, and play a particularly important role on over-the-counter markets where individual trades can be quite large. However, in facilitating trading, market makers can also have some unexpected impacts on the bid or ask price of a stock. In this article, we’ll cover the folklore of market maker signals and take a look at some real trading signals that are caused by market makers.

What is a Market Maker?

A market maker is typically a bank, brokerage, or another institutional investor that makes the market for a stock by buying or selling in response to orders. Thanks to market makers, you can buy and sell stocks even when there isn’t a corresponding seller or buyer lined up at the current market price. 

Market makers are quoting bid and ask prices and the volumes of stock they’re willing to buy and sell at any given moment. Typically, they can buy and sell at least 100 shares in any trade, but share volumes can rise into the tens of thousands for larger trades. Market makers make their money on the spread between bid-ask prices, and can quickly make thousands of dollars from the spread for large trades or for stocks with high trading volumes.

Market Maker Signals

Market maker signals are something of an urban legend among traders. Instant messaging among market makers about trades queued for execution is prohibited by the SEC to prevent insider trading. Market makers get around this – so the theory goes – by buying or selling shares of penny and micro-cap stocks in increments of several hundred shares at a time. 

For example, an order for 100 shares of a stock might signal to other market makers that the issuer wants to purchase a much larger number of shares of that stock. An order for 300 shares might indicate to other market makers that the stock price should be brought down so that shares can be bought up from frightened sellers.

These signals are clear to other market makers because the value of shares being traded is less than the commission required to place the trade. Orders of several hundred shares of penny stocks likely aren’t coming from retail investors.

Still, take all of this with a grain of salt. There’s relatively little evidence that market maker signals are real. 

Real Market Maker “Signals” To Pay Attention To

Whether or not you believe in market maker signals, market makers can play games with the market in order to increase their own profits. The ripples that market makers cause to bid and ask prices are real, although they’re generally restricted to penny stocks and micro-caps.

Controlling Market Makers

One thing traders should pay attention to when trading penny stocks on over-the-counter markets is whether a single market maker is controlling most of the order flow. This is likely a sign that the market maker is filling a large order, and may artificially keep the bid or ask price consistent for most of the day by only buying or releasing shares at a certain price. The purpose of this for the market maker is that it allows them to successfully fill a large limit order. 

In this case, the market maker is suppressing or inflating the price of a stock – right up until their large trade is nearly finished. Once the order does complete, prices can move sharply to respond to bid and ask prices from across the market for that stock.

Fake Order Size

Market makers can also “trick” the market by releasing an order that’s larger or smaller than the number of shares they really want to buy or sell. As an example, say a market maker puts out an order to sell 10,000 shares of a stock, but really has 100,000 shares to sell. In that case, they might be able to keep the price of the stock artificially high for most of the trade by not letting on that the market will soon be flooded with shares.

Fake Orders

Along the same lines, market makers can artificially push prices around by entering fake orders. Say a market maker issues an order to buy 100,000 shares of a stock, but withdraws the order after only buying 10,000 shares. In that case, the market maker can temporarily move the price of the stock up and create a larger spread in the process.

Conclusion

Market maker signals may or may not be real, but that doesn’t mean that market makers can’t have an effect on prices in the penny stock and micro-cap markets. Still, it’s important not to be overly concerned with market making tactics that push the price of a stock around. By taking responsibility for your own trading and focusing on a profitable strategy, you can largely insulate yourself from any shenanigans that market makers can possibly cause.

It’s universally true that, as the markets evolve, so must our trading. Lately, one trend in particular that you’ll want to take note of is the near elimination of any liquidity in the OTC and Pink Sheets markets.

Liquidity is the friend of the trader – and a lack of it is the enemy.

If you’re trading penny stocks, you’re working with stocks that may not allow you to get in and out at will. Being able to make a profit buying at $0.75 and selling at $0.80 requires the ability to flip the stock quickly. And if the trading volume just isn’t there, you may find yourself stuck holding shares long after your ideal price target has passed (or never arrived!).

Penny stocks were never the most liquid investments to begin with, but recent trends suggest that even the trading volume that was there is tanking. The huge lack of liquidity in the OTC and Pink Sheets markets means that savvy traders need to start looking for the next opportunity – and I’ve got just the thing…

More Stable Trading Opportunities

The potential rewards of penny stocks have always drawn investors who aren’t afraid of a little risk – those who are willing to forego secure fundamentals and SEC filings for the chance of catching a stock’s major runup (or shorting it on the way back down).

And can you blame them? If you’ve got 5,000 shares in a stock trading for $0.75 a share and it suddenly runs to $1.00 on positive news (or hype) with strong volume , you’ve just pocketed a 34% profit ($1250) – something that’s incredibly difficult or even impossible to do when working with larger cap companies on the “real” exchanges.

“Liquidity is the friend of the trader – and a lack of it is the enemy.”

But what if I told you that there’s a way to enjoy these same benefits of these low-priced stocks, while also minimizing the risk of getting caught in a position with low liquidity?

The answer is as simple as how you set the filtering options on your trading platform.

Here’s how to do it in EquityFeed (though you can apply this same process to any other platform, if if offers the necessary options) :

1. First, limit your searches to the NASDAQ, NYSE and AMEX exchanges. Contrary to popular belief, there are plenty of “penny stocks” that can be found trading for less than $5 a share on these more-legitimate exchanges. If you can find them, you’ll take advantage of the added liquidity, tighter spreads and price stability they offer.

2. Next, search for stocks that trade between $0 and $5.00 a share. If you’re going after the huge returns that come with timing penny stock setups correctly, this threshold will give you the best balance between the size of the position you can take on and the company’s potential for appreciation.

3. Set your liquidity parameters. The specific liqudity range you choose should be informed by your personal trading rules, but for a starting point, consider looking for stocks that have traded at least 100,000 on the current day and at least 100,000 on average per day over the last 20 days (20 ADV).

4. Use your platform’s filtering tools to find stocks with more stable price action. If you’re using EquityFeed, use the “Change” filters to set “Net Change”, “5 Min. Net Change”,  “Change from Open” or other parameters to something that’s in-line with your trading rules and preferred risk-reward ratios.

A Sweet Example

Let’s take a look at an example of a stock that these filters would have found. The company ticker symbol is XCO traded on the NYSE, and the chart pictured below comes from Wednesday, March 25th, 2015.

As you can see, the company had really nice, stable price appreciation throughout the last 2 days from about $1.60 to $1.96.

In the image below, you can also see the kind of unmatched volume (offered by the NYSE on such low-priced stocks) that would have allowed you to get into and out of your position with very little liquidity risk:

Overall, the dollar volume and number of trades for this indicate a great pick. Not only would you have been able to enjoy the volatility of a penny stock, but you’d be protected from potential losses due to its exceptional trading volume.

Obviously, I have to include a caveat here… You can’t rely on a trading platform to make all your stock picks for you. A stock could meet all the criteria you’ve set and still not be a good choice, but you’ll only know that if you do your own homework before deciding to take a position. Remember, if a trading platform could map out your trades for you with a 100% success rate, there’d be a lot more millionaire traders in the world.

“There’s a way to enjoy the benefits of penny stocks, while also minimizing the risk of getting caught in a position with low liquidity.”

That said, if you’re tired of the risk that comes along with traditional penny stocks – or if you’ve seen the writing on the wall in terms of vastly decreased liquidity in the OTC and Pink Sheets markets – you don’t have to give up their volatility (and the profit potential that comes along with it) altogether.

Instead, learning to better control the filters used on your trading platform gives you the opportunity to trade up to a better, more stable marketplace, all while maintaining the growth and returns potential you enjoyed as a OTC penny stock trader.

Are you seeing evidence of liquidity changes in the penny stock markets? Share how you’re adjusting to or handling these changes by leaving me a comment below!