OTC stands for "over the counter" and refers to stocks that are not listed in a public stock exchange such as the New York Stock Exchange. The term liquidity refers to the ease with which you can buy or sell an asset at any time. Investing in illiquid assets carries significant risks, which you must thoroughly grasp if you are to embark on such an adventure.
Exchange vs. OTC
Famous stock exchanges, such as the New York or Frankfurt Stock Exchange, exist to ensure orderly, safe and secure transactions between buyers and sellers. These stock markets impose several rules to protect buyers and sellers, which gives investors the confidence they need to invest their hard-earned money in stocks that change hands in these markets. Any stock that does not change hands in an organized exchange is said to trade over the counter. Colloquially, these stocks are referred to as OTC stocks. Since only a few thousand stocks change hands in a major stock exchange around the world, only a small minority of all stocks in the financial system are traded in an exchange. Most stocks in the world are actually OTC.
The term liquidity is a broad concept and refers to the frequency with which a financial security changes hand. A major stock, such as Microsoft, is said to be liquid. Almost every stock investor knows about it and at any given moment there are countless individuals and institutions waiting for an opportunity to buy or sell the stock. Therefore, Microsoft shares change hands frequently and in large numbers. Most stocks that trade in an exchange are fairly liquid. OTC stocks are almost always less liquid than exchange-traded stocks, because most investors prefer the safety and convenience associated with buying stocks through a public exchange. With fewer interested buyers and sellers, OTC shares simply cannot change hands as frequently.
Inability to Sell
A major liquidity risk you will face when trading OTC stocks is simply being unable to sell your holdings when you need to. If there are too few buyers and sellers following a stock, an interested buyer may not be available exactly when you need to sell. Of course, it may be just as hard finding shares to buy when you wish to invest. This is a relatively less dangerous situation, however, than being stuck with shares that you cannot liquidate when you need money ASAP. With the advent of the Internet, it is far easier for buyers and sellers of OTC securities to find each other. But the process is still far harder compared with trading in an exchange.
Bid Ask Spread
Even if the OTC stock you wish to trade is relatively liquid and there are buyers and sellers at all times, the bid-ask spread will likely be fairly broad. Bid is the price at which you can sell, and ask is the price you must pay to buy. If the bid and the ask on a stock are $10.50 and $11, respectively, and you buy 1,000 shares, you will pay $11,000. If the stock's price has not moved after a month and you must sell your shares, you will only be able to get $10,500, however, losing $500 even though the stock didn't budge. OTC shares always have large bid-ask spreads, resulting in potential losses when selling holdings if the stock fails to appreciate.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.