The 2013 movie Wolf of Wall Street, starring Leonardo DiCaprio as Jordan Belfort, follows the life of a stockbroker who got his start trading penny stocks to investors. For his work, DiCaprio was nominated for a Golden Globe. The real Jordan Belfort wasnt so lucky, netting a four year prison sentence for his crimes against investors.
The story of Jordan Belfort is, unfortunately, most peoples first and only exposure to the concept of penny, micro-cap and over-the-counter (OTC) stocks. And if you ask any financial advisor, theyll likely tell you that the rich and famous lifestyle and incredible ROI that you see on the big screen are incredibly unlikely to occur in real life.
This isnt to say that micro-cap and OTC stocks dont have their place and function in the financial marketplace. For many corporations, its the only way that investors can put their financial support behind the company. Theres just a few more things that investors need to know before they venture into this sub-section of the stock market.
TL;DR
- Micro-cap stocks and penny stocks are terms used to refer to securities offered by companies with small (micro) market capitalizations. To be considered a micro-cap stock, a company generally must have a market cap of less than $300 million.
- OTC stands for over-the-counter, just like it does when referring to certain drugs and other pharmaceutical products.
- DBOT ATS, Global OTC ATS, and OTC Link ATS are three of the primary OTC trading systems that investors can use to access the OTC market. All three of these systems are regulated and monitored by FINRA (Financial Industry Regulatory Authority).
- The biggest risks associated with micro-cap stocks are that the companies listed dont have to meet the strict regulatory requirements imposed by markets like the NYSE and NASDAQ. Some OTC systems require companies on their platform to meet requirements, but they pale in comparison to the larger exchanges.
What is a micro-cap stock?
A micro-cap stock is often referred to in conversation as a penny stock, and the two terms can by and large be used interchangeably with one another.
Generally speaking, to be considered a micro-cap stock, a company must have a market capitalization of under $300 million. If that still sounds like a lot of money, it is, depending on who or what youre comparing it to. Facebook (NASDAQ:FB), for comparison, has a market capitalization of $733.62 billion. For this reason, Facebook would be considered a large-cap stock.
What is a large-cap stock? We thought youd never ask.
Different caps
Stocks and their underlying companies can be sectioned off into five different classifications, based on their market capitalizations. These classifications, and their required market caps, are as follows:
- Large-cap: $10 billion or more
- Mid-cap: $210 billion
- Small-cap: $300 million$2 billion
- Micro-cap: $50300 million
- Nano-cap: $50 million or less
What does this all mean, and why should retail investors care?
First, we have to understand that a companys market cap isnt the same thing as its share price, but they are closely related.
A market cap is the value of all of a companys outstanding shares, multiplied by the stocks price. So, a company with 20 shares outstanding, with each share trading for $10, would have a market cap of $200. Real numbers will never be this small, and most likely wont be as pleasant to deal with either, but well use them for the sake of keeping things simple.
As a final note, its important to know that while micro-cap stocks are often referred to as penny stocks, that name can be misleading. Stocks for micro-cap companies dont always have to be trading for under a dollar, although they often do. There really is no limit on the price of a stock for a micro-cap company, as long as the total market capitalization remains under $300 million.
What is the OTC market?
When people refer to the OTC market, theyre usually using it as a blanket term to encompass multiple systems and trading platforms, such as:
- OTCBB
- Pink Sheets
- DBOT ATS
- Global OTC ATS
- OTC Link ATS
As mentioned before, the OTC market is a far less regulated (if at all) market where small-cap stocks are traded. Because these stocks usually have a much lower volume being traded than securities offered on larger exchanges, they pose increased risks. Much of this risk is because they’re unlike larger stocks that have much research and analysis offered on them by a variety of different services and other financial institutions. OTC stocks aren’t available on a lot of online brokerages in the U.S. for this reason.
Not all OTC stocks are inherently risky. One sector in particular falls under this category: cannabis. Because marijuana use isn’t federally legalized in the US, companies have to trade in Canada and on the OTC. On the contrary, Canadian-based cannabis companies can trade on U.S. exchanges.
With the low volume of stocks being traded, it can sometimes be hard to execute a trade on the OTC market. When dealing with large-cap stocks, there is often enough volume being traded that when you go to buy or sell a stock, there is always a buyer or seller immediately available. The same cant be said for OTC stocks, so investors often put a limit on the order in case the price of the stock changes.
Related: What is fractional investing?
How to use the OTC to trade micro-cap stocks
Before you decide to invest in micro-cap stocks, you should make sure that youre comfortable with the increased risks associated with trading OTC. Yes, theres risk associated with all investing, but OTC trading poses risks that even the most volatile of large-cap stocks dont. This is why big traders often neglect this part of the market altogether.
The second step would be to choose a broker. This is an important part of any trading, but only certain brokers allow access to OTC trading, so it adds an extra level of attention needed to this step. After youre all set up with a broker, you can begin trading OTC. Make sure that youre up-to-date on your brokers fee structure, and begin doing extensive research on any micro-cap stocks youre interested in.
While there are plenty of viable up-and-coming companies that trade OTC, there are also plenty of instances of fraud, since OTC stocks have such limited levels of regulation.
Related: What are blue chip stocks?
Bottom line
The world of micro-cap and penny stocks is often grossly misunderstood. Whether it be the incredibly low ROI, the next-to-none regulations on securities, or the low volume of trading, OTC markets pose risks that arent found on large exchanges. An extra level of caution needs to be exerted when considering moving into OTC trading, and investors should ask themselves if this added risk is worth the low likelihood of securing a profit.
As with investing in large-cap stocks, investors should have an investing strategy laid out beforehand, in addition to their research. Its possible to find success investing in micro-cap stocks by trading in OTC markets, as long as youre prepared to do your homework beforehand.