Liquidity Risk of OTC Stocks

Over-the-counter stocks are the scrawny cousins of the big-shouldered stocks that swagger around on the New York Stock Exchange and the Nasdaq. The companies whose shares trade "OTC" are usually small and often troubled (or worse). Many investors steer clear of OTC stocks entirely, meaning that if you've got some shares to sell, you might not find anyone to buy them. In finance, they call this liquidity risk.

OTC vs. Exchanges

When people think (or talk) about stocks, what they usually have in mind are stocks that trade on exchanges, such as the New York Stock Exchange or the Nasdaq. For each stock, exchanges match thousands or millions of orders a day from buyers and sellers. If a stock doesn't trade on an exchange, it's by definition an over-the-counter stock. Trades of OTC stocks are handled on computer networks run by dealers and brokers, where far fewer traders typically will be looking to buy or sell a given stock.

OTC Characteristics

Unlike exchange-traded stocks, which must meet specific criteria to remain listed on an exchange, OTC stocks face minimal standards. For example, OTC stocks don't have to maintain a minimum share price, and many sell for pennies a share. They don't have to be widely distributed, so a handful of shareholders can own enough shares to manipulate the price. Issuers don't have to disclose much information about their finances, and few analysts or journalists follow OTC stocks, so it's hard to study up on them. The OTC market includes many legitimate companies, but it also includes many troubled or insolvent companies. Some companies whose stocks that trade over the counter are little more than names -- not exactly the sort of companies a lot of people want to sink their nest egg into.

Low Liquidity

The liquidity of a stock refers simply to how easy or hard it is to sell it, and OTC stocks are substantially less liquid than exchange-traded stocks. (Some are so illiquid that they might as well be "solid.") With so much uncertainty (or perhaps mystery) surrounding companies on the OTC markets, many investors make it a policy never to buy OTC stocks. Major institutional investors -- the pension funds, insurance companies and other big-time investors that have billions of dollars to play with -- won't touch them. A holder of an OTC stock looking to sell shares is going to find fewer buyers and might not find a buyer at all.

The Risk

Low liquidity hurts stockholders trying to sell shares. Imagine you bought stock in an OTC company at $2 a share. You see the stock rise to $3, and you want to sell to lock in your 50 percent profit. However, the current "price" of a stock is simply the price in the most recent trade. With heavily traded stocks, you should be able to get close to the current price. With low-liquidity OTC stocks, you might put in an order to sell and discover that no one is offering $3 anymore. The stock might drop and erase your gain entirely. It's even worse when you're trying to sell to cut your losses but you're unable to find a buyer.


About the Author

Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.