When options trade between private parties, the security is an OTCOS. In comparison to exchange-traded options, those trading OTCOS do not face standard expiration dates and strike prices.
Options trading in the over-the-counter market are set on terms determined by parties involved. While there is less regulation in comparison to options on the NYSE, OTC markets require policies and eligibility requirements to operate.
What Is the Over-the-Counter Market?
The over-the-counter market (OTCM) is where securities investors have access to trade through broker networks. This allows for more flexibility for investors to make trades that are formed based on the parties needs.
Theses securities aren’t traded over the main exchanges because they’re between companies that have much less capital and do not qualify to be listed on major exchange networks. When trades are made on the OTCM, companies are faced with fewer regulations.
In turn, there are often lower costs due to the extreme competition when pricing options. Because of this there is more competition from companies providing OTC options, leading to lower priced options.
How Do Over the Counter Options Work?
In order to begin trading on the OTCM it’s important to first determine how much you are comfortable investing. While investing higher percentages into the traditional exchange is better for long term investing, OTC options should be seen as extremely risky.
The OTC option trades directly between the buyer and seller, leading to no standardization of strike prices and expiration dates.
What Firms Are in the OTC Market?
OTC market groups operate through the OTCQX (Best Market), OTCQB (Venture Market), the Pink Open Market, and the Grey Market. These are a few of the most reputable and commonly used markets to trade OTC options.
Tier 1: OTCQX
Companies trading through tier one must meet specific financial standards that follow excellent practices and comply with U.S securities law.
Tier 2: OTCQB
Companies that trade on this tier will not meet all financial requirements to trade on exchanges or the OTCQX. These companies are usually new and don’t have the capability to trade in large quantities.
Companies trading on the OTCQB have a bid price of at least $.01.
Tier 3: Pink Open Market
The Pink Open Market allows for brokers to trade on a transparent platform. Almost all companies qualify to trade on the Pink Market, even if the company has gone under.
Tier 4: Grey Market
Securities that trade over the Grey Market are not priced by broker dealers because there is such a lack of information.
Types of OTC Securities
Securities that are traded on the OTCM are traded through dealer networks instead of centralized exchanges. Securities traded through broker dealer networks are usually smaller companies unable to meet the requirements, to trade on formal exchanges.
American Depository Receipts
American depository receipts, or ADR, allows the owner the right to obtain the foreign stock it represents, but U.S. investors typically will prefer to own the ADR. Investors can purchase ADRS through brokers who obtain ADRS by creating new ADR or by purchasing pre-existing ADR issued in the NASDAQ, NYSE, and the OTC market.
Investors often seek out ADR to diversify their portfolio and invest into foreign stock.
Bonds allow investors to hedge their portfolios when entering into speculated contracts.
OTC derivatives are private contracts that are determined by parties, without having the need to go through any formal intermediary. Derivative values are based on assets such as stocks, currencies, interest rates, and market indexes.
What Are the Risks Trading in OTC Markets?
It’s difficult for investors to clearly estimate how securities will perform, due to the lack of information on them. Also, along with the wide bid-ask spread that happens since trade volumes are low.
Lack of Reliable Information
Unlike traditional stocks traded on the major exchanges, many of the readily available OTC stocks are privately held and therefore do not have to meet certain requirements. Companies that do trade on the OTC market have less protocol to follow which allows for them to not disclose all company information.
With far less ability to understand the financial state of the company, those looking to trade on the OTCM are often taking a much bigger risk. With such high risk in the OTCM, traders are often made to believe in unbacked reports which can lead into investing in falsehood.
Those looking to invest in the OTCM must keep in mind that the information and news reports given out aren’t always what they seem to be. Always use extreme caution before putting large portions of your portfolio into the OTCM.
The bid-ask spread affects the price of the securities being traded, this is due to the fact that all securities being traded depend on supply and demand. This means the more investors are looking to buy, the more bids that become available.
While if there are more bids, there will be more sellers willing to make trades.
What Is the Difference Between OTC Markets and the NYSE?
The main difference between the two is the fact that investors can’t trade OTCOS on formal exchanges such as the NYSE. Also, OTCM requires companies to disclosure little to no information on financial reporting, while companies trading over the NYSE require companies to disclose this information.
Options trading through the OTCM trade through broker dealer networks in comparison to how stocks trade on the NYSE. It’s also important to note that securities listed on the NYSE are more expensive than securities traded on the OTCM.
This is because companies have more exposure on the NYSE compared to trading through broker-dealer networks. OTC stock are also difficult to liquify quickly compared to stock trading on the NYSE.
Typically, this is due to the fact that there isn’t such a high demand for these securities. While there is little to no instantaneous information for securities on the OTCM, trading decisions are often more difficult to strategically make in comparison to securities on formal exchanges like the NYSE.
Should I Buy OTC Options?
Now that you have a better understanding, itll be easier to decide if OTC options are ideal for you. OTC stocks allow for investors to make trades with lesser known companies and companies that trade in forigen markets.
While the companies are much smaller on the OTCM, investors will have the ability to invest more and benefit from having a higher stake in companies. For this reason trading on the OTCM can be extremely beneficial to someone willing to take on higher risk for the potential of receiving high reward.
When OTC Options Might Be Right For You
It’s important to understand the OTCM and why you want to benefit from it. If your goal is to diversify your portfolio, adding foreign companies and smaller companies from the OTCM might be perfect for you.
But for those wanting to invest safely, with minimal risk, and readily available information, avoid OTCM options.
Getting Help Understanding OTC Options
Trades made on the OTCM come with much higher risk than trades made on formal exchanges. It’s important for investors to recognize that having limited knowledge on how OTC options work can be extremely risky.
Because companies trading on the OTCM have less readily available information, it’s important to contact a financial advisor before jumping into contracts. Find out what a financial advisor can do for your portfolio.